On the 17th July, the Italian authorities began the liquidation of Banca Romagna Cooperativa (BRC), a small Italian mutual bank that had been in trouble since 2013. In the BRC resolution process, equity and junior debt have been bailed in. The case has passed largely unnoticed abroad, but this is effectively the first instance of a bail-in in Italy.

Percentage of bank bonds in total bond portfolios of Italian Households

Source: elaboration based on data from Central Bank of Italy

The need to carry out a preliminary bail in in bank resolution cases was established in the amended state aid rules, which constitute the transition framework to the new recovery and resolution regime that will be in force from 2016. The amended state aid framework prescribes that a bail in of junior debt must be carried out before any public money can be injected into the bank.

The rules will be toughened starting in January 2016, when the bail-in tool foreseen under the Bank Recovery and Resolution Directive (BRRD) will become operative. The spirit of this provision is to ensure that the private sector bears a share in the recapitalisation, restructuring or resolution of troubled banks and to avoid the burden being entirely shifted onto the public sector balance sheet, thus reinforcing the sovereign-banking vicious cycle that the creation of Banking Union is supposed to counteract.

In a press release assessing the case, Fitch Ratings said that the initial plan in the Italian case was to use funds from Italy's Deposit Guarantee Insurance Fund to make up for the capital shortfall. But under the amended state aid, a preliminary bail-in of junior debt is mandatory. Therefore, junior bondholders have been bailed in. And yet they haven’t.

Despite the bail-in, in fact, no loss was suffered by retail bondholders as the Italian mutual sector's Institutional Guarantee Fund decided to reimburse them in full to “preserve the reputation of the sector”. The Institutional Guarantee Fund is technically not public money (it’s financed contributions from banks) but this still looks like a circuitous way to do what was initially planned, i.e. to avoid placing losses on private creditors. A few months ago a similar case (Carife - Cassa di Risparmio di Ferrara) also resulted in a "creative" solution being proposed, with the Italian deposit guarantee scheme Fondo interbancario di tutela dei depositi (FITD) possibly bailing out the bank and becoming the sole shareholder with the intention to sell it in the future.

The reason behind this is that all junior debt in BRC was actually held by retail depositors. This is by no means exclusive to BRC, but it points to a broader issue that could raise problems in the future. Households in Italy are relatively exposed to bank debt, which accounted for over 40% of the total bond assets held by households in the first quarter of 2015 (down from a peak of almost 60% in 2011/12).

According to Fitch, the BRC case highlights generally“poor conduct by Italian banks in raising subordinated and hybrid debt through their retail branches”. The Bank of Italy recently warned about the risks of institutions placing their own debt to retail buyers under the changed resolution landscape.

Italy is among the countries that failed to comply with the January 2015 deadline for implementing the BRRD into national law, but its transposition will limit the degrees of freedom over “creative” solutions like BRC and CARIFE. This may turn out to be a non-negligible problem for those smaller Italian banks that have relied heavily on retail customers to invest in less secure funding instruments.

What’s at stake: Neo-Fisherism is on the blogs again. The idea that low interest rates are deflationary – that we’ve had the sign on monetary policy wrong! – started as a fringe theory on the corners of the blogosphere 3 years ago. Michael Woodford has now confirmed that modern theory, indeed, implies the Neo-Fisherian view when people’s expectations are infinitely rational. For Woodford, this is however a paradox of perfect foresight analysis, rather than something actually relevant for monetary policy.

Are low interest rates deflationary?

Noah Smith writes that over the last three years, a quiet rebellion seems to have sprung up in macroeconomic circles. For some time, it was limited to a few whispers, a couple of papers, and the odd blog post or dinner speech, but it represents a striking break from conventional thinking and is being now addressed by leading New Keynesian authors. The rebellious idea is that low interest rates cause deflation, and high interest rates cause inflation. Noah Smith writes that the Neo-Fisherite idea doesn't just discount the effectiveness of monetary policy (like RBC models do, or like the MMT people do) - it stands that whole monetary policy universe on its head. If the Neo-Fisherites are right, then not only is the Fed massively confused about what it's doing, but much of the private sector may be reacting in the wrong way to monetary policy shifts.

Tony Yates writes that this discussion is not of purely academic interest, though it sounds nerdy and pointless. Recall where it started. Core inflation is sliding in the US and the ECB. Does this mean that central banks should double down and keep rates lower for longer, or is low inflation, by contrast, caused by the low rates? It’s pretty crucial to settle this. The discussion connects with recent efforts by central banks to stimulate the economy by announcing that rates will be held low, and fixed, at their natural floors, for long periods of time, before eventually rising, a policy they have dubbed ‘Forward Guidance’.

Ryan Avent writes that the basic logic of the argument is as follows. The economy has an equilibrium real, or inflation-adjusted, interest rate. The real interest rate is essentially the nominal interest rate minus the inflation rate. So if the central bank pushes nominal interest rates down to a low level, then over the long run the inflation rate must inevitably move toward a level consistent with the long-run equilibrium real rate. That is, inflation must fall. Otherwise, the economy would be out of equilibrium forever, which is not how economies work. John Cochrane writes that in response to the interest rate rise, indeed in the short run inflation declines. But if the central bank were to persist, and just leave the target alone, the economy really is stable, and eventually inflation would give up and return to the Fisher relation fold.

Noah Smith writes that the opening shot of the Neo-Fisherite rebellion was fired by Minneapolis Fed President Narayana Kocherlakota, in a speech in 2010. The second outbreak of the rebellion came when Steve Williamson wrote a paper in which QE is deflationary and the blog debates it sparkled. The third outbreak happened this month when Michael Woodford directly tackled the Neo-Fisherite view at the NBER Summer Institute.

2. Can one maintain the orthodox view — that maintaining a lower nominal rate for longer should cause higher inflation and capacity utilization — while having a view of expectations that implies that central-bank commitments regarding future policy should have any effect?

Mariana Garcia Schmidt and Michael Woodford write that people are at least somewhat forward-looking; this is why commitments regarding future policy matter. The assumption of perfect foresight is nonetheless very strong — especially in the context of a novel policy regime, and the anticipated effects of policies announced for many quarters in future Perfect Foresight Equilibrium (PFE) predictions are relevant only to the extent that the PFE is the limit of an iterative process of belief revision and this process converges fast enough for the limit to well approximate the outcome from a finite degree of reflection. But if the process doesn’t converge, the PFE prediction may be quite different from what this model of expectation formation would imply, even if the process of reflection is carried quite far. When considering the case where interest rate is expected to be fixed indefinitely, the authors show that belief revision dynamics don’t converge.

John Cochrane writes that what he can glean from the slides is that Garcia Schmidt and Woodford agree: Yes, this is what happens in rational expectations or perfect foresight versions of the new-Keynesian model. But if you add learning mechanisms, it goes away. His first reaction is relief -- if Woodford says it is a prediction of the standard perfect foresight / rational expectations version, that means I didn't screw up somewhere. And if one has to resort to learning and non-rational expectations to get rid of a result, the battle is half won.

As discussion continue in the Greek parliament and in Bruxelles on the next steps towards the third Greek programme, the Greek finance ministry published the latest budget execution bulletin, with data up to June and comparing the actual outcomes with the estimates presented in the 2015 budget.

The state budget primary balance picked up again in June, compared to the previous month. Greece recorded a primary surplus of 1.9 billion euros over the first five months of the year, against an expected primary deficit of 1.2 billion euros. In cumulative terms, the state primary balance has therefore exceeded its target by 3.1 billion euros (figure 1).

Source: Ministry of Economy and Finance, Greece

Revenues appear to have picked up in June, after the dismal performance in May (Figure 2). For the month of June alone, net revenues amounted to 3.2 billion euros, 360 million euros short of the monthly target. State budget net revenues amounted to a cumulative 21.8 billion euros for the period January-June 2015, still missing the target by 906 million euros. The ministry of Finance does not offer any explanation for the behaviour of revenues in June. Last month, it had said that the big shortfall in revenues recorded in May was partly attributed to the fact that the first installment of corporate income tax was not received (worth an estimated 555 million euros), so this may have come in in June and be partly responsible for the improvement. Ordinary budget net revenues amounted to 19.8 billion Euros, 1.7 million lower than the target on a cumulative terms. For the month of June in particular, ordinary net revenues were 701 million Euros below target.

Source: author’s calculations based on MEF bulletin

As it has become the norm for Greece since the beginning of the year, expenditures have been lower than expected. For the month of June, state budget expenditures amounted to 3.2 billion euros, i.e. an impressive 1.5 billion lower than the target, with ordinary budget expenditures under performing by 1.1 billion. Over the period January-June 2015, cumulative state budget expenditures amounted to 23.2 billion euros, 4 billion lower than the target. Ordinary Budget expenditures amounted to 22 billion euros and decreased by 3 billion against the target, again mostly due to the reduction of primary expenditure by 2.6 billion euros.

Source: Ministry of Economy and Finance, Greece

In June, the Greek primary balance has picked up compared to the dismal performance in May. However, this was once again the result of severe cuts in primary expenditure, most of which reflects arrears, according to local news report. Revenues have increased in June (although part of the increase may be due to the coming in of corporate income taxes that had been missed i May) but they continue to underperform both on a monthly and on a cumulative basis.

June data do not yet include the impact of the capital controls which had to be introduced at the end of the month when Prime Minister Tsipras called the referendum on the potential agreement with Greece’s creditors. Data for July will incorporate the full effect of the capital controls and will be key to watch because, as previously shown and as evident in figure 4, it is the most important month for revenues formation in Greece. The European Commission has already revised its estimates of real GDP growth for Greece downwards, between -2% to -4.0% in 2015, compared to the +2.9% projected in Autumn '14 forecasts and +0.5% in Spring 2015 forecast. this will certainly hamper the feasibility of the previously discussed fiscal targets, which is probably the reason why there is still no primary surplus target specified in the text of the preliminary agreement.

The agreement reached at the Eurosummit in the early hours of on July 13[1] marks yet another dramatic turning point in the five-year history of attempts to avoid Greece’s sovereign default and its potential exit from the euro area. It is too early to say whether it will be successful or not. Many important details such as fiscal targets, other conditionalities, the scale of emergency financing, resolution of Greece’s large public debt and distressed banking sector will have to be negotiated in the coming weeks and months. On the other hand, the political commitment and administrative capacity of the current government of Greece to deliver on such an ambitious reform program remains in question.

Nevertheless, perhaps it is the right time to look back and reflect on the experience of Greece and other countries who have implemented rescue programs and reformed their economies in distress to draw lessons. These may help in future policy choices. Below I offer five but it is not a complete list.

Lesson 1: Fiscal Sustainability Constraints Hold

Similarly to microeconomic agents (enterprises, households), governments cannot endlessly spend more than they receive in the form of tax and other revenue. They can do so only temporarily as long as there are creditors ready to lend. If a government goes too far it risks sovereign insolvency. Once it becomes bankrupt, a government must start running a balanced primary budget even if it totally negates on its outstanding liabilities to creditors. The reason is simple: no fresh financing is available. In most cases, this requires drastic fiscal policy tightening (elimination of a primary deficit). This is an elementary piece of fiscal arithmetic frequently forgotten in the debate in the Greece situation.

Greece overspent for decades, running fiscal deficits well in excess of the 3% Maastricht criterion (Figure 1) and building its public debt up to an evidently unsustainable level (Figure 2). The bust came in 2010 when private creditors refused further lending at reasonable price. They were replaced and partly bailed out by the official creditors (see Lesson 5) and Greece could continue public borrowing. In fact, the subsequent rescue programs monitored by the ‘Troika’ allowed Greece slowing the pace of its fiscal adjustment as compared with a scenario of no rescue program (as noted by Olivier Blanchard[2]) in exchange for promise of reforms, which have never been fully implemented (see Lesson 3).

In spite of its numerous weaknesses (see Lesson 3), Greece’s rescue programs started to bring positive results in 2014, including a primary fiscal surplus, some improvement in competitiveness[3] and the beginning of economic recovery. However, after negation of the ongoing rescue and reform program by the Syriza government (validated by the results of July’s referendum – see Lesson 4) the official creditors lost their appetite for further support - at least on the same conditions.

Figure 1: Greece: GG fiscal balance, % of GDP, 1980-2014

Source: IMF WEO, October 2014

Figure 2: Greece: GG gross public debt, in % of GDP, 1980-2014

Source: IMF WEO, October 2014

Because other euro area countries are not ready to offer Greece unconditional transfers the country faces two choices: either accept the creditors’ conditions and receive a third bailout program, or default, allowing the banking to sector collapse and probably leaving the Euro[4]. However, the second scenario will not make macroeconomic and fiscal choices easier. The Greek authorities will have to run at least a primary fiscal balance and tight monetary policy to avoid hyperinflation. The reforms required by the creditors will have to be carried out anyway.

Lesson 2: The role of trust

During the dramatic negotiation of 11-13 July 2015, many commentators pointed to the lack of trust between the government of Greece and its creditors - and rightly so. This trust has never been strong given numerous past episodes of statistical misreporting and the slow pace of Greek reforms (see Lesson 3). But it has definitely been devastated by the erratic behaviour of the Prime Minister Alexis Tsipras and the former Minister of Finance Yanis Varoufakis over the course of almost half a year of negotiations on extending the previous rescue program, including its sudden breaking off, calling a referendum and agitating for the “No” vote.

However, the trust has been lost not only in relations with official creditors. Business and market confidence has been also damaged by the Syriza government as evidenced by the returning recession in the first half of 2015, the decline in tax collection and massive capital flight. The government has become cut off from any form of market borrowing again, even short term. Breaking off negotiations with creditors and calling the referendum triggered a run on banks at the end of June which led to suspending most of their activities, limits on cash withdrawals and capital controls. Most importantly, the populist ploy with the referendum and then a total negation of its result has undermined trust between the Prime Minister and large parts of the Greek population, including his own political supporters (see Lesson 4).

When trust is devastated and a country is bankrupt the idea of continuing counter-cyclical fiscal fine-tuning to boost growth, as advocated by the anti-austerity zealots such as Paul Krugman[5] and Joseph Stiglitz[6], does not make much sense. In fact it looks like an evident misreading of Keynesian theory. In the case of Greece, slower fiscal adjustment means two things: (i) slower pace of important structural and institutional reforms (overhaul of VAT, pension reform, privatisation) which are important for growth; (ii) an even higher public debt burden, which undermines business and consumer confidence and, therefore, kills growth prospects.

Thus, rebuilding trust in all the above-mentioned dimensions is the absolute priority for Greece and a precondition to return to economic growth and financial stability. It requires among other things radical changes in the way in which economic policy has been conducted (see Lesson 3).

Lesson Three: Speed of Reforms and Their Ownership

A month ago, I wrote on the slow-reform trap in the context of Ukraine[7]. However, all arguments used then (changing expectations, producing visible reform results early enough, political economy) apply to Greece too. As documented by Anders Aslund[8], Latvia, which was also hit by a severe financial crisis in 2008-2009, managed to overcome its negative consequences and return to rapid growth in 2011 and to fiscal surplus in 2012. This was possible due to a frontloaded large-scale fiscal adjustment and a comprehensive package of structural and institutional reforms.

In fact, the election victory of Syriza in January 2015 was a product of slow reforms. Since 2010, the Greek people has had to absorb the pain associated with the crisis and reforms (slower reforms do not mean less pain) but without clearly visible gains. This made many of them receptive to populist arguments and promises.

A slow pace of reforms usually signals the limited political commitment of the government. In this context, Kenneth Rogoff[9] underlines importance of the so-called country ownership of a reform program. If such ownership is lacking, even the best-designed rescue program and its conditionality will not work. In case of Greece, ownership of reforms has been always problematic.

I am afraid this could also pose the biggest challenge for the new program. Even if Greek society is ready to accept some unpopular measures to stay in the euro area and regain access to its bank accounts, such support will not be automatically translated into a new parliamentary majority able to form effective pro-reform government. Greece may face months of political instability and uncertainty. On the other hand, the high-degree of intrusiveness of the new program (which can be seen as creditors’ insurance against a doubtful reform commitment from the Tsipras government) may easily produce a new wave of populist backlash once the danger of immediate Grexit disappears.

Lesson Four: Democracy Must Involve Responsibility

The referendum of 5 July 2015 raised huge excitement as a supposed evidence of Greece’s vibrant democracy and aspiration to regain a sovereignty compromised by the bailout programs. Joseph Stiglitz went even further in suggesting “Europe’s Attack on Greek Democracy” [10].

Indeed, a referendum can be one of the instruments of a direct democracy. However, in the discussed case it was heavily abused. First, it was organised in a rush and, most probably, breaching the constitution of Greece which (rightly) does not envisage possibility of referenda on financial matters. Second, the question asked was too long, unclear and not easy to understand for the general public. Third, the government information campaign was not fair, i.e., it did not present a real choice faced by the country. In fact, the Prime Minister offered society “you can have your cake and eat it too”. Fourth and most important, the day after the referendum the same Prime Minister negated its results and accepted (or even went further than) the deal which he recommended (successfully) to reject. Thus, the 5 July referendum did not serve to strengthen Greek democracy but, somewhat naively, to impose pressure on creditors. Obviously, populist games of this kind can only undermine democracy.

More generally, democracy must involve responsibility for the decision taken, including all hardships associated with wrong choices - in particular if they have been repeated several times as in the case of Greece. In this context, it is difficult to accept Barry Eichengreen’s view that “Greece deserves better. It deserves a program that respects its sovereignty and allows the government to establish its credibility over time” [11]. Who is going to pay for this better program?

Here we touch another important question: democratic mechanisms and decisions must respect limits of their jurisdiction. They cannot burden other countries with the consequences of their own choices. Governments of those other countries must follow preferences and limits on their actions imposed by their own electorates (see comment of Dani Rodrik[12]).

The Greek society and its political elites must accept the unpleasant fact that the range of available economic choices for a bankrupt country is more limited in comparison with a solvent one and think how to reform Greece’s political systems to avoid repeated incidences of economic mismanagement in the future.

Lesson Five: Rules Are Important

The first rescue program for Greece meant circumventing an important market discipline rule written into Article 125 of the Treaty on the Functioning of the European Union (TFEU). The so-called “no bailout” clause was replaced by the quite complicated mechanism of conditional bailout, i.e. financial assistance in exchange for fiscal adjustment and structural and institutional reforms. Article 123 of the TFEU, which prohibits European Central Bank (ECB) and national central banks to finance governments has been also compromised by a large ECB exposure to Greece sovereign bonds and the mechanism of Emergency Liquidity Assistance (ELA) which supports Greek banks against the guarantees of their insolvent government.

At the same time, as noted by my colleagues Ashoka Mody[13] and Guntram Wolff[14], the International Monetary Fund (IMF) breached two of its operational principles, i.e. lending only against the program, which offers a convincing solvency perspective (regaining market access) in its life horizon and so-called private sector involvement, i.e. participation of commercial creditors in debt restructuring. None of these conditions was met in May 2010 but some corrections (debt restructuring deal with private creditors) came in 2011-2012 with the second bailout program.

Whatever has been the reason to breach both EU and IMF rules (primarily, the fear of market contagion in a situation when most EU governments remained heavily over-indebted and large European banks are heavily exposed to the sovereign debt of peripheral euro area countries) now the official creditors must pay a heavy price for that.

First, there is a classical moral hazard problem, both for private creditors and sovereign borrowers. As demonstrated by the behaviour of Syriza government (and demand of populist parties in other European countries) this is not a hypothetical threat.

Second, as in the experience of many federal states (for example, Argentina, Brazil or Russia in the 1990s) lack of discipline on a sub-federal level may easily lead to a fiscal crisis on a federal level and destabilise a common currency. Fortunately, the EU/EMU did not get to this point yet.

Third, if the federal level lends to a distressed and undisciplined sub-federal entity it quickly becomes its financial and political hostage. This is indeed the most dramatic dilemma faced by the euro area countries and the ECB today: allow Greece to go bankrupt and accept loses on the outstanding claims on Greece, or continue lending and increase their exposures, even if chances of debt repayment remain highly problematic. The July 13 agreement can be seen as a dramatic attempt to keep Greece afloat but at least partly reinforce rules. It remains to be seen whether this attempt has any chance to succeed.

Finally, despite the declared solidarity with Greece (and other euro area countries in distress) the subsequent bailout programs did not increase the degree of political cohesion within the EU and EMU. On the contrary, it provoked a distributional conflict between creditor and debtor countries (especially in the case of Greece) and waves of nationalism and populism in various countries. Solidarity is perhaps a nice idea but not necessarily in the realm of inter-governmental fiscal relations.

Today the European Court of Justice (ECJ) will rule on a dispute between Chinese tech companies Huawei and ZTE regarding a patent “essential” to the “Long Term Evolution” (LTE) wireless broadband technology standard. The legal dispute originates in the Düsseldorf District Court (Landgericht Düsseldorf), where Huawei sought an injunction against ZTE after attempts between the two companies to find an agreement on fair, reasonable, non-discriminatory (FRAND) terms were unsuccessful. This ruling is highly anticipated since it is likely to bring some clarity over what are to be considered in Europe anticompetitive conducts in relation to Standard-Essential Patents (SEPs), an area where several high-profile cases (e.g. Samsung and Google/Motorola Mobility) have been recently investigated by the European Commission.

Standards foster economic development. They reduce transaction and production costs; they increase efficiencies, limit asymmetric information between producers and consumers, make it more viable to invest in innovation and reduce the level of uncertainty about the outcome of R&D investment. Standards ensure network interoperability: to be sure, when you pick up your mobile phone and call a friend, you are happy that your devices can easily interconnect through the same network technology. But standards are tricky matters for antitrust authorities. Once competing technologies are eliminated in favour of the selected technology, the owners of patents essential to that standard might try to extract monopolistic rents from users of the technology. To avoid this, standard-setting organisations usually require patent owners to commit to charge a FRAND price once the standard has been adopted (see Mariniello 2013). This is what the European Telecom Standardisation Institute did when the 4G LTE standard was adopted.

The main question the ECJ judgement is supposed to provide a reply to is under which conditions a SEP-holder seeking an injunction is abusing its (presumed) dominant position. The Advocate General’s opinion published last November, while non-binding, is likely to provide a preview of the content of the ECJ ruling. In the Advocate General’s opinion, a SEP-holder seeking an injunction is not breaking its FRAND commitment and abusing its dominant position if, before seeking the injunction:

i. it notified the alleged infringer that it was infringing some of its SEPs and

ii. it engaged in negotiations by presenting the alleged infringer with a written offer on FRAND terms specifying all terms and conditions that are part of a normal licensing contract in the sector, including the royalty rate to be applied and the way it is calculated.

In turn, a prospective licensee must respond to that offer in a diligent and serious manner in order not to be considered “unwilling” to reach an agreement. If the prospective licensee does not accept the SEP’s offer, it must promptly come up with a reasonable counterproposal. Even in cases in which an agreement between the two parties could not be ultimately found, the alleged infringer’s behaviour should still be considered willing to reach an agreement if it offers to have the FRAND terms of the licensing contract determined by a Court or an arbitration tribunal. Finally, the prospective licensee conduct should not be considered as dilatory or not serious if it reserves the right to challenge the validity of the patent in court. This is good, as there is a public interest in having “bad” patents (i.e. patents which should not have been issued in the first place) invalidated and prospective licensee should not be forced to give up this right in order to have access to technology the licensor has promised to provide under FRAND terms. If the alleged infringer does not follow these steps and its conduct can be characterised as purely tactical, dilatory or not serious, the request for an injunction by a SEP-holder does not constitute an abuse of dominant position, according to the Advocate General.

In practice, for the Advocate General both the SEP holder (licensor) and the alleged infringer (prospective licensee) should comply with their duty of good will and engage in a constructive negotiation in order to achieve a mutually satisfactory solution. The framework proposed by the Advocate General therefore balances the interests of prospective licensees, which made standard-specific investments relying on the licensors’ promise of giving access to the technology on “fair, reasonable and non-discriminatory” terms and may see these investments “held up” by the SEP-holder, and the ones of licensors whose already-sunk own R&D investments could be “reverse held up” by a “tactical” licensee. In so doing, this opinion is welcome.

The opinion also briefly discusses whether holding a SEP should immediately imply a dominant position, arguing that while the essential nature of the patent is likely to make dealing with a SEP-holder indispensable for any prospective licensees, this presumption should be rebuttable if sufficient evidence of the contrary is provided.[1] Once again the opinion seems to strike the right balance between preserving the rights of patent holders while protecting potentially locked-in licensees.

[1] The right time when to evaluate the indispensability, and therefore whether the SEP-holder is to be considered dominant, is the time when the agreement was sought. It would be mistaken to determine that a SEP-holder was not dominant because ex-post the patent is discovered to be invalid or not essential to the standard, since the prospective licensee, at the time of the negotiation might have been unable to foresee such an occurrence and would have likely negotiated under the presumption that the patent was both valid and essential.

Germany is 'Exportweltmeister' (world champion in exporting) as it is phrased by the German media. Between 2000 and 2013 German exports increased by 154 percent compared to 127 percent in Spain, 98 percent in the UK, 79 percent in France and 72 percent in Italy. In addition, no other European country saw such a quick rebound in export growth after the financial crisis in 2009 as Germany. As a result, many observers see Germany as a leading role model of successful adjustment from the 'sick man of Europe' in the 2000s to an economic powerhouse today. What has contributed to this exceptional export performance of Germany compared to other European countries?

Wage Restraint

The two leading explanations for Germany's superb export performance are wage restraint and the emergence of China. And indeed, wage bargaining among the social partners resulted in an increase in nominal wages and salaries in Germany of only 19 percent between 2000 and 2008, the lowest increase in the European Union (in Spain nominal wages increased by 48 percent during the same period).

However, since 2009 nominal wages started to rise again in Germany. From 2009 to 2013 German nominal wages increased by over 14 percent compared to 4 percent in Spain. In spite of this rapid rise in nominal wages, German exports rebounded quickly compared to other European countries. Thus, wage restraint cannot be the full answer.

The Rise of China

Has Germany benefited more from the opening up of China compared to other European countries? This indeed appears to be the case. In the five years after the financial crisis, German exports to China almost doubled, a stronger increase than in any other European country. There are two possible channels through which China may have benefited exports in European countries.

First, China may have become an important sourcing region lowering the production costs of European exporters. Our analysis of the sourcing pattern of European exporters indicates however, that the biggest gainers from sourcing in China were the UK and Austria. UK exporters, who offshored to China, almost doubled their export market share to the world, while Austria’s exporters increased their export market share by 70 percent compared to exporters, in these two countries, which did not offshore to China. In contrast, for the export market share of Spanish, German, and French exporters, sourcing from China was only marginally important. Thus, the spectacular success of German exporters appears not to be based on access to cheap inputs from the Chinese market.

figure 1: export market share and sourcing to china

Note: Median firms’ export value/total imports of the world for the firm specific set of industries.

Second, the rapid modernization of China may have favored particularly Germany's exports with its comparative advantage in machinery, transport equipment and other manufactured goods. The data seem to support this. However, other European countries, such as France and Italy, also have a large base in transport and manufacturing goods. Therefore, the question remains: why have the Chinese such a love for German goods?

The Firm Organisation of Export Superstars

In order to get to an answer to this question we want to go deeper and examine the export business model which European firms have pursued to compete on world markets. We focus on two adjustments in firm organisation that may help exporting firms to meet competitive pressures from foreign rivals. Offshoring production to low wage countries reduce costs and allows exporting firms to compete on prices. Decentralized management provides incentives to workers for product improvements, which enables exporters to compete on quality. The idea here is that workers at lower levels of the firm hierarchy are better informed on what the market demands. Giving these workers more autonomy in decision making will provide them with incentives to adapt the product characteristics with what customers demand.[1]

We explore the organisational responses to competition of 14.000 firms in seven European countries. The analysis is based on the EFIGE data which we merge with Bureau van Dijk’s Amadeus database in order to get detailed balance sheet and industry information. Aggregate trade data at the industry level is obtained via WITS from the UN Comtrade database. To assess the competitiveness at the firm level we construct the export market share of the export superstars in Europe, the top 1 percent of exporters in terms of export value in each country accounting between 20% and 55% of total exports in the respective country.[2] What type of organization do these firms choose to become superstars in world markets? Did these firms do significantly better when using the firm organization as a competitive tool? Figure 2 reports the answer. [3]

Germany’s export superstars more than double their export market share in the world (from 1.6% to 3.5%) when they operate with decentralized management rather than not using the organization as a competitive tool (compare the export market share of the dec-exporters with the none-exporters in Figure 2). The top 1% of exporters which abstain from any organizational adjustment (the none-exporters in the figure) do very badly in all countries except perhaps Italy. Austria’s export superstars rely exclusively on decentralized management. Italian and UK top exporters rely exclusively on offshoring (off-exporters in Figure 2), while French and Spanish exporters combine offshoring with decentralized management (both-exporters in Figure 2) to compete on world markets. From Figure 2 a distinct pattern emerges: German export superstars base their export business model on quality by relying on decentralized management. Germany shares this feature with Austria, while all other European countries base their export business model on price by offshoring production to low wage countries with or without a care for quality.

figure 2: export market share of top 1% of exporters in percent

Notes: Export market share: Average firm's export value/total imports of the world for the firm specific set of industries. Top exporters are defined in terms of export value. none: neither decentralized nor offshoring, dec: decentralized firm, off: offshoring firm, both: decentralized and offshoring firm (categories are mutually exclusive). A firm is an offshoring firm if it has purchased inputs from abroad. A firm is a decentralized firm if managers can take strategic decisions autonomously in some business areas.

Product Quality: A subjective measure

We turn now to assess the product quality of exports across European countries. We use a subjective measure of product quality as perceived by the firms. Firms ranked the quality of their export goods relative to the market average in the range between 0 and 100. We define a good to be of top quality if it is ranked by the firms as 100. We report the results in Figure 3. Austria and Germany stand out. About 40 percent of exporters offer top quality goods relative to the market average in the respective country. In France only 10 percent of exporters have top quality goods.

figure 3: top quality exports in percents of firms

Next, we want to know whether decentralized management has, indeed, contributed to the pattern of quality across countries. This will be the case if decentralized management leads to an increase in the export market share of top quality goods. We report the results in Figure 4.

figure 4: export market share by top quality exporters (in per mille)

none: neither decentralized nor offshoring, dec: decentralized firm, off: offshoring firm, both: decentralized and offshoring firm (categories are mutually exclusive). A firm is an offshoring firm if it has purchased inputs from abroad. A firm is a decentralized firm if managers can take strategic decisions autonomously in some business areas.

German exporters impressively demonstrate that decentralized management can provide incentives for product quality. German exporters increase their export market share of top quality goods by a factor of almost 3, from 0.07 per mille of the median exporter to 0.2 per mille when they operate with a decentralized less hierarchical organisation. Spanish and British exporters also somewhat boost their export market share of high quality goods, while Austrian and French exporters do not improve product quality when they decentralize.

Product Quality: A measure of price vulnerability

An alternative measure for product quality is the ability of firms to raise their price without losing too much of their customers to competitors. This is captured by the elasticity of substitution between different varieties of the same good. It measures the percentage decline in the demand for a Volkswagen car when e.g. Renault lowers its price by 1 percent. Presumably, Volkswagen will experience less of a decline for its cars in response to a price reduction by Renault if it is of high quality. We use this to rank the industries by the size of the elasticity of substitution as estimated by Broda, Greenfield and Weinstein (2006). We define a good to be differentiated, responding only little to price changes, if the elasticity of substitution falls in the bottom 10 percent range. We define a good to be homogenous, responding strongly to price changes, if the elasticity of substitution falls in the top 10 percent range.

We now ask whether exporters of differentiated goods defined in this way can boost their export market share by significantly more when they operate with a decentralized organization. We report the result in Figure 5. We find that only British and German exporters boost their export market share of differentiated goods when they use decentralized management. Spanish, French and Italian exporters have to use both organizational margins to increase their exports of differentiated goods.

figure 5: export market share of differentiated goods (in per mille)

Notes: Export market share is the median firm's export value/total imports of the world. Homogeneous goods: elasticity of substitution is in the top 10 percent range. Differentiated goods: elasticity of substitution is in the bottom 10 percent range.

Conclusion

What explains Germany’s exceptional export performance relative to other European countries? We find that Germany is a world champion in exporting because it is a world champion in organizing. The export superstars of Germany base their export business model on quality by operating with a decentralized less hierarchical organization which empowers workers at lower levels of the firm hierarchy. As a result 40 percent of German exporters sell top quality export goods. Decentralized management has been effective to increase the export market share of top quality goods in Germany which demonstrates that decentralizing the organization may actually work to improve the product quality of exporters. Austria shares many of these features with Germany, while the superstars of all other European countries base their export business model mainly on price with or without a care for quality. The focus on quality may explain why export growth in Germany and Austria rebounded quickly after 2009 in spite of rapid rising nominal wages.

[1] For a model, see Marin, Schymik, Tscheke (2015). Marin and Verdier (2008, 2014) show that a more competitive trade environment leads firms to decentralize decision making to lower levels of the firm hierarchy. They find that firms decentralize in particular those decisions for which workers’ effort is most important, such as the decision over R&D and the decision to introduce a new product.

[2] It is a well-documented fact that only a few firms do all the exporting in countries, see Bernard et al (2007) for the US and Mayer and Ottaviano (2007) for Europe.

[3] We report correlations. In Marin, Schymik Tscheke (2015) we show that the causality runs from the organisation to the export market share.

In 1997, Milton Friedman warned that when politics clashes with economics, the outcome is not a pretty one. This column reviews some of criticisms and weaknesses of the European macroeconomic system, taking a historic look at the decades leading up to the creation of the euro. The clash Friedman warned about is manifest now in Greece. The economic logic for dealing with Greece is clear, but politics continue to defy economics.

Flexible exchange rates in the aftermath of the Great Depression

Up until the Great Depression of the 1930s, the predominant view was that national currencies should be exchanged at fixed rates. The expectation was that the rate would not be changed unless there was a compelling reason to do so. The success of the gold standard between 1870 and 1913 had deepened the faith in fixed rates. During those years, the world’s major economies had maintained a commitment to exchanging their currencies for a fixed amount of gold and, for much of the time, the world economy prospered. But the gold standard proved completely unworkable after 1913, and was, by Barry Eichengreen’s influential account, a major contributor to the severity of the Great Depression (Eichengreen 1992a). Fixed exchange rates, the Harvard economist Gottfried von Haberler later commented, became “a casualty of the Great Depression” (Habeler 1976, p.17).

That triggered a revolution in international macroeconomic thinking. In the 1940s, a new phrase, ‘flexible exchange rates’, appeared in intellectual discourse (Figure 1).1 Strikingly, Germans were the pioneers in discussing flexible exchange rates (‘flexible Wechselkurs’ or ‘schwankender Wechselkurs’) while the French showed the least interest (‘taux de change flexible’ or ‘taux de change flottant’).

Figure 1. The usage of the phrase ‘flexible exchange rate’ in German, English, and French books

<small>Note: The graph was created using the Google Books Ngram Viewer (https://books.google.com/ngrams/info). It reports the frequency with which the phrase flexible exchange rate is mentioned in the books scanned by Google; ‘flexible Wechselkurs’ was used for German books and ‘taux de change flexible’ for French books. The English variation ‘floating exchange rate’, the German variation ‘schwankender Wechselkurs’ and the French variation ‘taux de change flottant’ yielded similar trends.</small>

The immediate post-World War II monetary system was fashioned at that intellectual cusp. In July 1944, when policymakers met at Bretton Woods, New Hampshire, it was still hard to break free from the fixed exchange rate mind set. But in deference to reality, the new system allowed countries to ‘adjust’ their fixed rates under international supervision. To authorise these changes – and to oversee the world’s exchange rate policies – the IMF was created.

The system was short-lived. With capital criss-crossing the world in ever larger volumes, the fixed rates were continuously tested. In 1953, the University of Chicago economist and later Nobel Laureate Milton Friedman proposed the more widespread use of flexible exchange rates (Friedman 1953). As Figure 1 shows, the usage of the phrase ‘flexible exchange rates’ accelerated, once again in Germany.

Increasingly, however, countries were unable to maintain their commitment to a fixed exchange rate while also achieving their domestic policy objectives. In particular, countries experiencing high inflation rates needed to devalue to compete internationally. But the international community discouraged devaluation because it feared that others would follow by also devaluing to restore their competitiveness; and, domestically, governments faced the political charge of having mismanaged the economy. For this reason, devaluations tended to be delayed. In the meantime, financial markets –foreseeing an eventual devaluation – moved vast sums of money across borders to mount speculative attacks against vulnerable currencies. Such currencies were ultimately devalued despite a mélange of responses that included restrictions on imports, controls on capital movements, restrictions on prices and wages, and severe austerity (Bordo 1993, p.83).

It was only a matter of time. The US – the lynch pin of the Bretton Woods System – was running high inflation rates and could not sustain its commitment to pay $35 for an ounce of gold. On 15 March, 1968, the so-called ‘two-tier’ system was introduced under which central banks would transact only with each other at the $35 price and would no longer buy or sell at the market price. At that point, the monetary historian Michael Bordo says, the Bretton Woods system effectively came to an end. Since it had become fully operational only in December 1958, it had lasted for just under a decade (see Bordo 1993 for a more detailed account).

In a March 1969 paper, Harry Johnson – of the London School of Economics and the University of Chicago – restated Friedman’s argument. Greater exchange rate flexibility would allow national authorities greater freedom in domestic macroeconomic management. In contrast, he said, “little reasoned defence of [the fixed exchange rate system] has been produced beyond the fact that it exists and functions after a fashion, and the contention that any change would be for the worse” (Johnson 1969, pp. 12-13).

On 29 September 1969, Germany let its exchange rate float. Once again, the Germans were ahead of the Anglo-Saxons.

Initiating a European monetary union

And then Europe chose to go against the tide of history. The French steered Europe to its preference for fixed rates and the Germans, reluctantly at first, followed. In August 1969, the newly elected French President Georges Pompidou quickly devalued the French franc and made monetary union of Europe one of his priorities. Willy Brandt, who became West German Chancellor in October, was willing to test the idea so that he could gain space for reconciliation with the East, Ostpolitik. Thus Brandt agreed to Pompidou’s call for a summit of European leaders at The Hague in December 1969 to discuss, among other things, a European monetary union. The leaders created a committee headed by Pierre Werner, the Luxembourg Prime Minister, and in October 1970, the Werner Committee delivered its blueprint.

The Germans were not yet ready to concede. At the Franco-German consultations in July 1971, they reported on “the advantages [floating the D-Mark] had already brought” (Rutherford 1973). In October 1971, at the Annual Meetings of the World Bank and the IMF, German Economics Minister Karl Schiller stated, “the mechanism of exchange rate adjustment has been far too rigid… it is important that unrealistic parities [exchange rates] should be adjusted promptly and sufficiently. We ought to look at parity changes not as matters of political prestige and of victory and defeat but from a sober economic point of view” (Schiller 1971, p.195).

The Franco-German differences on exchange rates reflected a deeper difference in their view of the role of markets in determining economic outcomes. Their positions were starkly different even when negotiating the Treaty of Rome in the 1950s to open borders to European trade. The then German Economics Minister Ludwig Erhard opposed the Treaty because he wanted borders to be open for all countries, not just to other European countries. The French did not want to open borders, even to other European countries (Marjolin 1989, p.281).

But, as Figure 1 shows, in the early 1970s the German curve began to bend towards the French one. Not wanting to be seen as setting back the European integration process, the Germans fell in with the French. In 1972, following a recommendation of the Werner Report, the so-called ‘snake in the tunnel’ system was created as an effort to limit the bilateral exchange rates of major European economies. That arrangement was quickly swept away by the global turmoil of those years. In 1979, the exchange rate mechanism was an effort to revive the snake. Once again, countries were required to maintain their bilateral exchange rates within narrowly defined bands. It eventually went up in flames in 1992-93.

Despite repeated reality tests, successive French presidents continued to push for fixed exchange rates within a monetary union. For them, the dependence on German monetary policy was intolerable. The concern was most passionately stated by President Francois Mitterrand in a September 1989 conversation with British Prime Minister Margaret Thatcher: “Without a common currency, we are all, us and you, already at the will of the Germans. When they raise their interest rates, we are obliged to follow them, and you who are not even in the monetary system, you do the same thing! Thus, the only way to have a right to have a say, is to establish a European Central Bank where we can decide on things together,” Guigou (2000, pp. 76).

Notice that although the German intellectual discussion of flexible exchange rates declined after around 1970, it fell only to the Anglo-Saxon level. The French usage remained steadfastly low. Besides deep ideological differences, the Germans were always supremely conscious that a monetary union may force them to pay the bills of other nations that were unable to withstand the rigours of such a union. For this reason, the German public and the technocrats opposed the single currency. But one man pushed ahead: German Chancellor Helmut Kohl. From the summit of European leaders at Strasbourg in December 1989 (when he gave the go ahead to start drafting the Maastricht Treaty) to the summit at Brussels in May 1998 (when he insisted that Italy would be among the first members of the euro club), he shepherded the euro to its birth. In the process, he legitimised a new groupthink.

Critics of the common currency

Roland Benabou says that groupthink has four characteristics: a leader to champion a view; the disregard of external critics; the silencing of internal critics; and, as a consequence, the slide into missions of great – and unreasonable – risk.2

The conscious disregard of external critics is well known. A whole swathe of ‘Anglo-Saxon’ contemporary economists and policymakers warned against the dangers, starting with the University of Cambridge economist Nicholas Kaldor, who wrote a scathing critique a few months after the Werner Report was published.3

Among internal critics, some left and others aligned themselves to Kohl. Among the most prominent critics who chose to leave was Bundesbank President Karl Otto Pohl. Like all German civil servants, he deferred to the goal of European integration. But on the single currency, he was clear that Europe was not ready. And while it was possible to construct a technical vision of how such a currency may eventually operate, much groundwork, he believed, was needed before the conditions for success would be attained. In 1989, in the months before German reunification, Pohl made repeated public efforts to slow the process down. Indeed, on one occasion, he said that British Prime Minister Margaret Thatcher – the fiercest political critic of the single currency –understood the risks better than his own chancellor.4 Repeatedly undermined, Pohl left in May 1991 before his term ended.

Finance Minister Theo Waigel, personally at odds with Pohl, agreed with him on the economics. The two had opposed the conversion of one East German Ostmark for one West German D-Mark. Waigel also insisted on a slower pace of European monetary integration at least till the Maastricht Treaty in December 1991. But then he fell in with Kohl’s agenda. The compromise that Waigel shepherded was European fiscal austerity to protect Germans from picking up the tab for others. Once again, contemporary critics warned that this – along with a single monetary policy for disparate countries – would make macroeconomic management harder, especially in economic downturns. But disregarding those warnings, an incomplete monetary union, without the safeguards of labour mobility and a fiscal union, was forged.

Concluding remarks

Thus, at that bend in history – when politics defied economics – the European macroeconomics of austerity was born, protected by groupthink and necessarily cast in institutional straightjackets. Even as the Europeans narrowed their macroeconomic options, the rest of the world moved steadily to macroeconomic flexibility – in exchange rate, monetary, and fiscal arrangements.

In the run up to the euro in 1997, Milton Friedman warned that when politics clashes with economics, the outcome is not a pretty one. Today, the clash is manifest in Greece. Ironically, although the French intent was to reduce German influence, a more dominant Germany now determines how Europe sees its financial crisis. The economic logic and evidence for dealing with Greece are clear.[5] Politics, however, continues to defy economics and groupthink prevents the painful but sober course.

On 8 July the European Parliament – after a year-long saga of failed committee votes and rejected reports – finally voted to introduce a mechanism to stabilise the European emissions trading system (ETS). The Market Stability Reserve (MSR) adopted by the European Parliament is a measure to temporarily adjust the supply of emission allowances in order to boost the carbon price. As I argued back in 2013, I think the mechanism itself is inappropriate for ensuring an investible carbon price. The main value of the tool is thus not the mechanism itself, but the political signal of support from the European Parliament and the European Council for the ETS.

It is therefore interesting to look into the voting results – the most visible political signal. The main observation is that the carbon price did not markedly move after the European Parliament strongly voted in favour of the MSR (495 MEPs voted in favour, 158 against, with 49 abstentions). This signal was evidently anticipated, as there was almost no reaction on the day. Indeed, it was not strong enough: emission allowances are still trading at significantly lower prices than initially envisaged. This weakness of the political signal might be partially explained by the complicated parliamentary history of the MSR.

Emission allowance price:

The second interesting observation is that there is a strong positive correlation between countries’ per-GDP emissions and votes against the MSR. For example, most MEPs from Poland or Bulgaria (which are among the least carbon-efficient economies) voted against the MSR.

National votes against per-GDP emissions:

A third observation is that some fairly carbon-efficient member states such as France, Italy and the United Kingdom produced about twice as many ‘no’ votes than one would expect from their carbon-intensity. In fact, a large share of the ‘no’ votes came from MEPs representing parties such as the Front National in France (21 of 25 noes), UKIP in the UK (all 19 noes) and Movimento 5 Stelle in Italy (15 of the 20 noes). This might be explained by these parties general opposition to any European-level instruments.

Percentage of ‘no’ votes by party group:

In conclusion, the MSR vote did indeed deliver a political signal in favour of emissions trading in Europe. However, despite the strong positive result, the fine details are less encouraging.

Appendix - Results by country:

Appendix - European Parliament Political Groups:

S&D: Group of the Progressive Alliance of Socialists and Democrats in the European Parliament

GUE/NGL: Confederal Group of the European United Left - Nordic Green Left

Olivier Blanchard has, with his customary clarity and candor, addressed criticisms of the IMF’s role in Greece’s financial rescue. His is a personal statement. But in writing it, he also presents the IMF’s operating philosophy and mandate. Blanchard’s statement will, therefore, not only shape our thinking on the evolution of the Greek crisis but it could define how we view the proper role of the IMF. His blog post deserves careful reading and consideration.

The risk of contagion prevented debt restructuring

The critics, he says, complain that “The [official] financing given to Greece was used to repay foreign banks.” But that, Blanchard insists, is not the right way to think of it. Memories of the post-Lehman meltdown were still fresh. The risks of contagion were real, or were perceived to be real, and there were no firewalls to contain those risks. That is certainly the official view. But is it right?

· While a moment of great uncertainty, it was also a time for new ideas and initiatives. Barely 10 days after the Lehman fiasco, Washington Mutual Bank became the largest ever bank to fail in the United States and the U.S. authorities forced the creditors and equity holders to bear all the losses. The IMF, in contrast, went in the opposite direction, overriding its well-founded principle that the distressed country’s debt must be reduced to a “sustainable” level. In the Greek case, debt reduction required imposing losses on creditors. To the fear of contagion, a simpler solution—with much lower costs to all—would have been for the French and German authorities to stuff their banks with cash so that they were protected from the losses on their Greek debt holdings.

· If even with these efforts, the risk of a wild-fire contagion could not be eliminated, then the question should have been who should bear the burden of preventing the contagion. An IMF paper that bears Blanchard’s name lays out the principle by which Greece should have been compensated—with a financial grant (not a loan)—for agreeing to hold on to its unsustainable debt burden in the interest of limiting losses on others. The IMF paper says:

“[…] there may be circumstances where any form of debt restructuring … would be considered problematic from a contagion perspective. […] in these cases, sustainability concerns could be addressed not through a debt restructuring but through concessional assistance [the official euphemism for financial grants] provided by other official creditors.

The argument is that contagion is a global problem and the global community should share the cost of preventing contagion. Absent such burden-sharing, it is an arithmetical matter that the austerity required on Greece was much greater than it would otherwise have been. And before the terms of the official loans were finally eased, the wind was knocked out of the Greek economy.

But austerity was needed in any event

The critics, Blanchard says, are not right to complain that “The 2010 program only served to raise debt and demanded excessive fiscal adjustment.” Fiscal austerity, he insists, was not a choice, it was a necessity. He makes a strange claim:

“Had Greece been left on its own, it would have been simply unable to borrow. … Even if it had fully defaulted on its debt, given a primary deficit of over 10% of GDP, it would have had to cut its budget deficit by 10% of GDP from one day to the next.”

Surely, that is a non-sequitur. No one has proposed that the alternative would have been to leave Greece “on its own.” That is not what the IMF does. The process requires the creditors to bear losses and the IMF simultaneously provides temporary financing. Both help to ease the pace of fiscal austerity.

In any event, Blanchard says, Greece’s failure to grow was not because of “growth-killing” austerity but because Greece failed to implement structural reforms.

Here he departs from his own script. Speaking to Sky News in April 2013, Blanchard had warned the U.K. authorities that by indulging in obsessive austerity, they were “playing with fire.” Of the major industrialized economies, the U.K. was the slowest to recover from the crisis, faster only than Italy.

If austerity in the U.K. was like playing with fire, in Greece, it was like being in a choke-hold. Unlike in the U.K., Greece had no help from monetary policy; while the U.K. moved aggressively to stabilize its banks, Greek banks continue to be laden with non-performing assets. Without these aids, the entire burden was on Greek fiscal austerity. Greek public expenditure has come down by one-third since 2010; its structural budget deficit of 12 percent of potential GDP has been transformed into a surplus of 2 percent. These are extraordinary degrees of austerity.

Perhaps, the most famous scholarly paper of the crisis is by Olivier Blanchard and Daniel Leigh, in which they say that in the midst of a crisis, austerity slows growth down significantly. And extraordinary austerity slows growth by an extraordinary degree. And yet another IMF paper, this one by Luc Eyraud and Anke Weber, says that if austerity persists, output and incomes will fall and the debt burden will actually increase. The collapse in Greek output and the rise in the debt-to-GDP ratio were validation of these scholarly studies.

There is no acknowledgement in Blanchard’s blog of the very unrealistic expectations that underlay the growth and productivity consequences of structural reform. How could the IMF have assumed such a quick growth rebound without exchange rate flexibility and a global economy still dealing with its traumas? And with structural reforms necessarily designed to lower wages and prices, the debt burden of businesses and households was bound to rise, causing a further slowdown in growth and increasing the government’s debt burden.

The IMF has learned as the crisis has evolved

The critics say: “Creditors have learned nothing and keep repeating the same mistakes.” Not so, says Blanchard.

Between 2010 and 2012, Greek GDP fell much more than had been projected. In his blog, Blanchard says: “fiscal consolidation explains only a fraction of the output decline.” This is an odd claim, as also pointed out by Paul Krugman and Brad de Long. We know that the output collapse was, in large part, due to the severe austerity because the Blanchard-Leigh paper documents that:

Note: Figure forecast error for real GDP growth in 2010 and 2011 relative to forecasts made in the spring of 2010 on forecasts of fiscal consolidation for 2010 and 2011 in spring of the year 2010; and regression line.

Greece fits exactly the European pattern: the Greek economic contraction was so deep because its austerity was so stunningly large.

In December 2012—to retain access to the IMF’s funds—the Greek authorities dutifully said: “Despite the [fiscal] adjustment we have undertaken so far, further efforts are needed to restore fiscal sustainability.” A large adjustment was undertaken in 2013, GDP continued to fall; a small adjustment occurred in 2014 and GDP began to stabilize. So far, the evidence is pretty clear: more austerity, lower growth.

Then, in 2013 and 2014, prices fell by a cumulative 5 percent. This is Irving Fisher’s debt-deflation cycle. As more debt is repaid, demand for goods and services is held back, prices and wages fall, but because the value of debt outstanding does not change, the debt burden grows. This is not rocket science: the IMF’s own studies acknowledge that.

Yet, the IMF’s latest debt sustainability analysis continues to disregard that logic. The IMF projects that the Greek authorities will increase their primary surplus (the budget balance without interest payments) by a net of about 1 percent of GDP a year to about 3½ percent of GDP in three years. Along with continued deep austerity, the debt sustainability analysis also projects renewed growth and a rise in inflation. In combination, the value of GDP—so-called nominal GDP—is expected to grow at between 3 and 4 percent annually in the next two years. Maybe that will happen. But the evidence of the past 5 years says that it is far more likely that nominal GDP will contract by between 3 and 4 percent every year.

When the economy does eventually contract because of the debt-deflation cycle and persistent austerity, the blame will be on the events of the past few months. But it is important to remember that deflation had set in well before the new government came in. By early February, President Obama had diagnosed Greece to be in the midst of a depression. Yes, the past five months will make things worse; allocating the responsibility for that, however, must await a more careful accounting.

When the Greek economy does contract in the coming years, the blame will also be in the lack of structural reforms by the Greeks. Blanchard gives ammunition to those who will make that easy charge. But again, the IMF’s own research department cautions that the dividends from structural reforms are weak and take time to work their way through (see box 3.5 in this link). In contrast, the debt-deflation cycle and the contractionary effects of austerity work immediately. The risk is that the Greek economy may be deeply hobbled before any benefits of reforms show through.

Recall, that Greece has already undertaken heroic austerity, its growth has collapsed, and it has entered a debt-deflation cycle. Irving Fisher told us that at this point, only a reflation—the opposite of austerity—is needed to revive growth. We can all agree that reflation is not possible. But is more austerity really needed now? More to the point, is more austerity sensible now?

Policymaking works under political constraints

Twice in this remarkable essay, Blanchard refers to political constraints on the creditors that have restricted the scope of economic policy. In May 2010, he says, “there was a political limit to what official creditors could ask their own citizens to contribute.” Now, in 2015, he reiterates, “there were and are political limits to what they can ask their own citizens to contribute.” The IMF’s role, he says, is to point to the economic trade-offs, the politics dictates the decisions. Since creditors are unwilling to provide debt relief, the politics dictates that Greece undertake more austerity. That sounds right. But it is wrong on two counts.

First, the IMF’s role is not merely to explain the trade-offs; it is to help make smart policy choices. In this instance, debt relief by creditors now will prevent more debt relief (or larger defaults) later. If the likelihood is great that the austerity demanded will, in fact, lower incomes and increase the debt burden, then the saga we have gone through in the past several months is bound to repeat. Debt relief in driblets will increase the agony and pain of creditor and debtor alike.

Second, for the past several months, the IMF has stood shoulder-to-shoulder with the European creditors in requiring more austerity from the Greeks. Indeed, in demanding more revenues from value-added taxes and reduced pensions, the IMF’s voice has perhaps been the more strident one. But although Blanchard now confirms that the IMF had communicated the need for debt relief to the European creditors, this fact—that the IMF believed that substantial relief was needed—was not made public until the debt sustainability analysis was published on July 2, three days before the Greek referendum. In delaying the release of this analysis, the IMF acted in bad faith. An earlier release would have created a legitimate and transparent public counterweight to those opposing debt relief and would, thus, have weakened the political constraints and increased the prospects of a superior economic decision.

So, why did the IMF finally release its numbers on needed debt relief? The U.S. role is crucial. Although President Obama had in early February warned against squeezing a nation that was in the midst of an economic depression, the U.S. authorities remained disengaged from the discussions. Hence, the European creditors—with their significant voice on the IMF’s Board of Executive Directors—could hold sway. But finally, with the threat of Greece exiting the eurozone becoming real, the Americans woke up to the reality of financial and geopolitical turmoil. It would now appear that the decision to make public the analysis that Greece needed debt relief came at the prompting of the American authorities.

Only July 7, U.S. Treasury Secretary Jack Lew called for more debt relief by the European creditors, and nearly simultaneously, the IMF’s Managing Director, Christine Lagarde, made a nearly identical statement. Indeed, the IMF’s coy phrase “debt operations”—its code for debt relief—was dropped and “debt restructuring” could now be openly stated.

What lessons have we, in fact, learned?

The economics of a program design based on the IMF’s research, which I outlined on June 21 on voxeu, still looks pretty good to me. The primary surplus should be maintained at 0.5 percent of GDP for the next three years. There should be sufficiently large debt relief upfront—now, not as a vague promise to consider relief later—so that: (a) Greece is not forced to borrow new money from official creditors to repay their old loans; and (b) in three years, the debt burden is so low that Greece can borrow from private lenders with sovereign contingent convertibles to create a limit on the borrowing. Of course, the politics of this is impossible, as many would no doubt point out.

That the IMF operates under “political limits” is more troubling. The experience of the past few years is a reminder that the IMF acts in the (often misguided) interests of its major shareholders. For this reason, the IMF cannot be a technocratic institution that speaks truth to power. At crunch time, it must do as it is told. Thus, the question must be asked, why does the IMF exist, and for whom?

And, as for Greeks, in 2009, their problems were of their own making. But then they got trapped in a power play that took on a life of its own. In that power play, politics defied the economics. That should not have been a surprise: the euro emerged from a political process that defied economics. The past few years were merely a logical continuation of that economically illogical construction. The deal hammered out this past weekend—if it is a real deal—remains defiant of economic logic, and the likelihood is high that Greeks will suffer more pain and the creditors will eventually see less of their money. That ultimately is the Greek tragedy.

This blog draws two lessons from the failed Greek programme. Olivier Blanchard is right that the fiscal adjustment of the last 5 years was unavoidable. An earlier debt restructuring could hardly have prevented it. (1) However, an earlier debt restructuring would have allowed significantly lower primary surpluses from now on and it would have made the programme more credible. Higher confidence in Greece would have provided more political and financial stability, essential ingredients for growth. Financial contagion was probably an incorrect argument for delaying debt restructuring. Even if it had been right though, it did not change the underlying problem of debt unsustainability. (2) Equally important, the IMF failed to prioritise a strategy for Greece to regain competitiveness. The programme initially made a correct diagnosis of Greece’s major competitiveness problem. The problem was a result of the pre-crisis Ponzi scheme with ever-increasing deficits financing higher public salaries and rising pensions. However, conditionality on improving the business environment and product markets, augmenting competition and lowering wages through the abolition of the 13th month salary were weak or absent. This made a turn-around of the economy away from a bloated state sector towards a larger export sector impossible. Contrary to Portugal, exports hardly increased in Greece. Political economy considerations would have called for a frontloading of structural reforms for which the political energy in 2013/14 was clearly lacking – despite later IMF insistence on such reforms. These mistakes raise significant questions on the governance of the IMF. They also call for drawing the right lessons for the third programme.

The IMF’s chief economist, Olivier Blanchard, just came out with a robust defence of the IMF policy choices in Greece. His piece is clear and deserves careful reading and analysis. It is important to understand the key mistakes in the Greek programme and to draw the right conclusions.

Greece's 30 June failure to meet a payment obligation to the International Monetary Fund starkly exposed the wider failure of the Greek financial assistance programme. It was the biggest missed payment in the IMF's history and highlights the uncertain prospects of repayment of the €24 billion the IMF has outstanding to Greece. However, the IMF’s exposure is small compared to the exposure of the euro-area institutions, which amounts to more than €190 billion.

Five years after the start of the programme, what do we now know about the mistakes and what lessons should the Fund draw from the Greek failure? I would prioritise two points, which Olivier Blanchard does not sufficiently recognise:

Believe your numbers

Independent economists and IMF staff had doubts about Greek debt sustainability from the beginning of the programme. Instead of insisting on earlier and deep debt restructuring, the IMF agreed to change its internal rules to cater for financial stability concerns as a reason to overrule the sustainability doubts.

We now know that the financial stability concerns were overstated. We also know that they were not directly related to the Greek situation. Instead, the rising spreads elsewhere were largely a result of debt sustainability doubts in those territories. The absence of a proper lender of last resort was the other missing piece - until the European Central Bank stepped in with the Outright Monetary Transactions programme. The Irish and Portuguese programmes were bound to happen even without the crisis in Greece. As regards the banks in France and Germany, the direct exposure numbers were small compared to the overall size of the banking systems. They were also small compared to the bank rescue programmes enacted.

One has to concur though with Olivier Blanchard, that the policy system was genuinely worried about the debt restructuring. At the beginning of the programme, it was simply impossible to convince any policy maker that this was the right choice. However, the euro area lost substantial time until the decision to restructure was finally taken. The debt exchange happened only in March/April 2012, almost two years after the start of the programme. Moreover, the restructuring was executed in a way that made future debt restructuring more difficult as Zettelmeyer, Trebesch and Gulati point out. Pushing for an earlier debt restructuring and less generous terms for holdout creditors could have saved substantial resources to Greece.

In any case, even with financial stability concerns, the fact that Greece's debt was from the outset unsustainable should have been recognised. Financial contagion risk cannot be an excuse for ignoring sustainability.

The IMF should have assumed responsibility for this mistake early on and accepted the postponement of debt repayment – as the Europeans did in November 2012. The European debt moratorium significantly reduced the Greek debt burden. If the IMF had accepted delayed debt repayments similar to the Europeans, it would have gone a long way in preventing the current escalation of the situation: no new programme would have been needed to fund an IMF rollover.

More importantly, however, an earlier and deeper debt restructuring would have given more fiscal space for later years.

Even with earlier restructuring, I doubt that a slower fiscal adjustment up to now would have been feasible. Even with a full debt restructuring, creditors’ appetite to fund huge deficits would have been limited. In any case, up to now more than 40% of GDP worth of deficits has been funded by the programme. Olivier Blanchard clearly accepts the fact that deficits had to come down, although he has typically argued for less austerity. More specifically, he argues that

“Fiscal austerity was not a choice, but a necessity. .... The deficit reduction was large because the initial deficit was large. ‘Less fiscal austerity,’ i.e., slower fiscal adjustment, would have required even more financing ….”

Indeed, the initial deficit of Greece was extremely high, at 15% of GDP, and the Greek financial assistance programme is by far the largest in recent history. Here Blanchard is aware of the limits of what can be done with such starting conditions: fiscal deficits were too high and had to be reduced.

One can make this point differently: high deficits were the root of Greece’s problem, not the solution. Greece lost market access in early 2010 because its economy was severely imbalanced. Since joining the Euro, Greek governments had been running a Ponzi scheme by increasing their government borrowing every year, paying higher public wages and making the pension system more generous. Greek public sector wages more than doubled between 1999 and 2009, while increasing by only 40 percent in the rest of the euro area. Other economists such as Ricardo Hausmann have highlighted explicitly that Greece’s problem did not come from austerity. I clearly agree with Blanchard that deficits had to come down – this was an inevitable reaction to the unsustainable pre-crisis policies. One can debate the speed of fiscal adjustment but even spread over 7 years, it would have both been painful for Greece and it would have required more IMF/EU funding.

However, an earlier debt restructuring would have allowed for lower primary surpluses as of 2015. In our computations, a one percentage point lower primary surplus per year during 2015-2030 amounts to some 10% difference in the debt to GDP ratio by 2030. An earlier debt restructuring could have easily brought 10 or even 20% of GDP less debt, allowing for substantially lower primary surpluses going forward. Concessionary financing, as Olivier Blanchard argues, has helped. However, it was clearly not enough to restore debt sustainability.

In short, the IMF bears responsibility for not insisting earlier that the debt is not sustainable and asking for earlier and deeper debt restructuring. This would have allowed running a much lower and more realistic primary surplus target. Instead, the IMF accepted to structure the programme in a way that put all hope on higher future primary surpluses. The historical evidence, however, is rather clear that such high primary surpluses are extremely unlikely – and quite bad for economic growth especially when paid to external creditors. In contrast, contagion risk was probably overstated. Fiscal numbers that did not add up were also undermining confidence in Greece. With fiscal sustainability, there would be no Grexit debate now.

When you enter a programme, address all serious imbalances upfront

Greece had lost a huge amount of competitiveness relative to its partners. It was running current account deficits of well above 10 percent in the five years preceding the programme. This loss of competitiveness was driven by the bloated state sector but it extended to the entire economy. The programme should have prioritised restoring the competitiveness of the Greek economy. For this, an elimination of the 13th month salary in the private sector or a similar measure was inevitable. Yet, the IMF did not insist on this crucial point, despite discussing that it would actually be advisable (see point 43 in the staff agreement). Delaying it meant delaying the competitiveness adjustment. The result was a deeper recession as unemployment increased instead of wages.

In the public sector as well reforms were initially rather timid or inconsistent. The bloated state sector was tackled partly by reducing the number of public employees. However, early retirement schemes for public sector employees were put in place and these now cause significant problems in the pension system. This was not really a lasting solution.

In an upcoming Bruegel paper, Alessio Terzi shows how little emphasis was put on product market and business reforms in the first programme. Yet, the programme should also have prioritised product market reforms and productivity enhancing investment. It should have addressed vested interests as manifested in oligopolistic structures. Yet competition policy was hardly touched. With the second programme issues such as business environment finally became more important in the conditionality (see our blog here). However, during 2013/14, it became more and more difficult to enact any meaningful reforms in Greece. Conditionality on reforms thus came too late.

Yet, regaining competitiveness earlier would have allowed the export sector to pick up some of the slack in the economy. In Portugal, the cut in domestic demand was partly offset by a significant increase in exports of more than €10 billion since 2008. In contrast, exports in Greece have barely increased since 2008. Clearly, the programme did not do enough to achieve a turn-around in the export sector in Greece.

Political economy provides us with the simple insight that when a crisis occurs, there is only a short window of opportunity for deep reform. In the Greek case, the IMF failed to seize the opportunity of frontloading tough conditionality on structural reforms that would have boosted the export sector. Professor Blanchard only mentions that Greece did not comply with structural reform demands:

“Only 5 of 12 planned IMF reviews under the current program were completed, and only one has been completed since mid-2013, because of the failure to implement reforms”

This should come as no surprise. Since mid-2013, compliance with conditionality weakened as th economy weakened and interest groups had time to organise themselves. Political economy teaches us that resistance to reform will be fiercer the later the reform comes.

In conclusion

A combination of many factors is responsible for the failure of the Greek programme. We have argued that fiscal policy, lacking confidence, corrupt elites, a lack of competitiveness and weak productive structures combine to explain Greece’s miserable performance. Professor Blanchard shares this view: “But fiscal consolidation explains only a fraction of the output decline. Output above potential to start, political crises, inconsistent policies, insufficient reforms, Grexit fears, low business confidence, weak banks, all contributed to the outcome”. Generations of empirical economists will struggle to assign percentages to the different mistakes.

Yet, the IMF spectacularly failed on two fronts: earlier debt restructuring and substantial and early reforms to restore the competitiveness of Greece. The former would have allowed running lower primary surpluses in the future. It would have made the programme more credible allowing confidence to be restored; the latter would have been the best way of minimising the unavoidable shrinkage of the Greek pre-crisis bubble by boosting exports.

One can debate whether the IMF is the main institution responsible for the failures in the design of the programme. Certainly, the EU institutions played a major role. However, the IMF participated in the programme to be an independent and experienced institution. If it made those mistakes because the European institutions overruled it, it should draw the right lessons for its governance and its participation in financial assistance programmes as a junior partner.

Going forward, the IMF should indeed be the impartial voice of reason on Greece and resist political pressure. Numbers are merciless and politics can ultimately not overrule them. The following things are central:

- The IMF should insist on lower primary surpluses going forward. Achieving a primary surplus of 3.5% would trigger a further substantial shrinkage of the Greek economy. Entering a third programme with these numbers and only later organizing debt relief is counterproductive. Fear of Grexit does not make a programme sustainable.

- The IMF should seize the opportunity of new programme discussions to insist on structural reforms that matter for growth. Political ownership of reforms is crucial.

- Finally, the IMF should review its governance and its participation in financial assistance programmes as a junior partner.

The Europeans needed the independent outside view of the IMF to start their first programme. Five years on, the IMF is still needed as a voice of reason. It should learn from its mistakes.

· Regaining the stability of the Greek financial sector is key, as a meltdown could lead to Grexit. The stability of the Greek financial system currently relies on the provision of ECB liquidity, which in turn is only available to solvent banks.

· While Greek banks were found to be solvent and well capitalised in the AQR, the deterioration of the economic situation over these months has been such that this assumption may now be questionable. The quality of capital is also put at risk by the heavy reliance of Greek banks on Deferred Tax Assets instruments.

· The draft text discussed in the Eurogroup yesterday suggests that the potential package for Greece would include 10 to 25bn for the banking sector in order to address potential recapitalisation needs. Rumours this morning suggest the banks would then become part of a new asset fund and sold off to pay down debt. Recapitalisation can be done in different ways, with different consequences. Here, I compare four possible scenarios to recapitalise the Greek banks.

· Europe disposes of an instrument to recapitalise the Greek banks limiting impact on the Greek debt, while at the same time awarding the ESM more control on the banking system. This instrument is the ESM tool for direct recapitalization, born with the initial aim to break the sovereign-bank vicious cycle and never used as of today.

· The back of the envelope calculations included here will show that the problem with the instrument as it currently stands is that it would require, before the ESM can step in, a very significant bail-in of 8% of total liabilities. Given e structure of Greek banks’ liabilities, meeting this requirement would need a 100% haircut on junior and senior (non-government-guarantee) bonds plus very high haircut on uninsured deposits (up to 39% in one bank).

· On the basis of the exercise performed here, the best solution to recapitalize the Greek banks would be to make use of the ESM direct recap but in a way that allows it to make an actual difference, i.e. limiting bail-in to what is currently mandatory under the amended State aid requirement.

Greek banks: illiquidity or insolvency?

Time is the scarcest commodity in Greece, at the moment. Stabilising the Greek financial system is vital at this juncture. Without the ECB liquidity provision, Greek banks are unable to convert their assets into the cash that their depositors are demanding to withdraw. At present, with a cap on ELA and a consequent limit on cash withdrawals and transactions, Greece is already in a limbo. The euros held in Greek deposits are entirely fungible with the euro held elsewhere only up to 60euro per day. If the ELA were to be terminated – as likely in the absence of a deal – the banks would effectively run out of cash and collapse. A significant part of heir assets – which is currently pledged as collateral for the ELA – would be seized, as the banks would have no cash left and would certainly not be in a position to repay the ELA funds. At that point, the banks would need to be heavily restructured, as their asset side would have collapsed. In the absence of financial assistance coming through rapidly, this would entail either massive bail-in or recapitalisation from the government. But since the government is cash strapped and cannot inject euros into the banks, a banking sector melt down would probably force a redenomination of asset and liabilities, thus automatically leading to exit.

The stability of the financial sector hinges on the ECB liquidity provision, which in turn requires the solvency of Greek banks. The AQR’s results – showing that Greek banks were adequately capitalized last year – have allowed justifying ELA until now. But since then the economy has deteriorated and the level of NPLs has increased markedly. Walsh and Wolff (2015) show that the four major Greek banks have been under severe stress following the market turbulences caused by political uncertainty, with their market value plummeting. Using 2014 balance sheet data they show that the existing book equity would be significantly reduced in all four banks by a large loss on non-performing exposure. The resulting book value would be relatively close to the actual market value of these four banks – suggesting that further losses may be priced in (and therefore considered likely) by the markets.

The quality of capital is also called into question due to the high share of Deferred Tax Assets (DTAs)/Deferred Tax Credits (DTCs) included the Core capital calculations and the specifics of the Greek DTC conversion law. The Greek law initially required that if a bank calling on the DTC as capital failed to produce profits in the future, the government should provide the equivalent of the tax refund in government bonds. However, the EBA asked Athens to amend the law, so that the government contribution would need to be in cash. In light of the developments over the past few weeks, Greek banks are unlikely to post profits, and the Greek government is cash-strapped. Therefore, the dependence of capital ratios on DTAs is especially problematic and the features of the Greek conversion law suggest that an important part of capital could be de facto wiped out by the circumstances, if not by supervisory action. DTAs in fact amount to 42% to 57% of CET1 in Greek banks (Table 1).

Table 1 – DTAs and capital of Greek banks

Source: RBS and other market research; author’s calculations

A default of the Greek government on the ECB-held bonds – which is growing in likelihood – would negatively affect banks’ balance sheets and potentially undermine all government-guaranteed debt. As of May 2015, government bonds accounted for 3% to 5% of total assets of the four banks considered here. A default of the Greek government would render meaningless the guarantee on government guaranteed instruments, including government guaranteed bank bonds, which represent a significant part of senior debt issued by Greek banks (table 3). A default would further negatively affect the Greek economy, which has suffered from payment delays by the Greek finance ministry during the last 6 months. This would in turn affect the NPL numbers. Such an event would certainly increase further the ECB haircut on ELA collateral, thus tightening the liquidity constraint.

The draft text discussed in the Eurogroup today suggests that the potential package for Greece would include 10 to 25bn euros for the banking sector, in order to address potential recapitalisation needs. In this piece I look at potential scenarios for recapitalising the Greek banking system, starting from a hypothetical loss assumption. As highlighted above, recapitalisation would give a strong backing to the continuance or even extension of full ELA provision by the ECB. My idea is to compare the implications of different recapitalisation options, with a special focus on the ESM direct recapitalisation instrument. Summary results are as follows:

· Scenario 1: no public money; restructuring without sovereign default. A capital shortfall would remain even after a full bail-in of subordinated/other bonds as well as of the senior bonds that are not government guaranteed. Under the more conservative assumption to exclude DTAs from capital, then a haircut of uninsured deposits between 7% and 38% would be needed, depending on the bank. Even if DTAs were counted in, Piraeus and Eurobank would need at least an 11% haircut on uninsured deposits.

· Scenario 2: no public money; restructuring with sovereign default. Sovereign default implies that the government-guaranteed bonds can undergo a haircut and increases the pool of bondholders on whom losses can be imposed. After a full bail-in of subordinated/other bonds, the remaining shortfall could be met with a haircut of 15% to 41% on senior debt, without touching depositors, even under the most conservative assumption of excluding DTAs from capital. Default has however very significant impact on the asset side and on liquidity, which make it very undesirable (the reason why scenarios 3 and 4 are examined).

· Scenario 3: ESM direct recap with bail-in of 8% of total Liabilities (as per ESM direct recap guidelines). Bail-in would require full haircut of subordinated/other bonds, full haircut of senior non-guaranteed bonds and still a haircut of uninsured deposits ranging between 13% and 39% for three out of four banks. This would already bring all banks above the 4.5% CET1 threshold and two of the banks above 8% CET1. The remaining capital shortfall would be covered by the ESM and Greece together, but the Greek contribution could be suspended. The ESM would effectively play only a very limited role.

· Scenario 4: ESM direct recapitalisation with bail-in as in the amended State-Aid guidelines. The amended State aid guidelines require only bail-in of junior debt in the transition to the Bank Recovery and Resolution Directive (BRRD). After a 100% haircut on subordinated/other non-senior debt, the banks’ CET1 would still be below 4.5% in some cases. Under the ESM direct recap’s priority ranking, Greece needs to bring the banks to 4.5% CET1 before the ESM steps in and take them to 8%. With a conservative DTAs assumption, the contribution to reach 4.5% could be substantially bigger than the ESM contribution for those banks that are less capitalised and that do not have much bail-in-able junior debt. However, this contribution could be suspended by mutual agreement in light of the fiscal situation of Greece. If so, the ESM would play a more meaningful role.

The underlying shock assumptions

All the scenarios presented here start from the same assumption as far as the potential capital shortfall is concerned. I start from the assumption made in a recent report by RBS (RBS Credit, The Silver Bullet 7 July 2015), which estimated the impact on CET1 of an increase in NPL by 20 percentage points, at 50% recovery rate. NPL are already very high as a proportion of total loans in Greek banks, and the recent developments – with restrictions on payments and capital controls – will certainly result into an increase. Under this assumption, CET1 losses range between 5.3bn and 7.4bn. This loss almost completely wipes out CET1 and results into an aggregate shortfall of €16bn for the four banks to be restored at a CET1 ratio of 8%. If we were to exclude DTAs from capital – for the reasons previously highlighted – the impact would be even more dramatic, bringing CET1 into negative territory. Under this assumption, the aggregate shortfall to CET1 of 8% generated by the shock considered would be €29.5bn for the four banks considered.

Table 2 – capital ratios and assumptions

Source: RBS and author calculations

Given this shock, I look here at four potential scenarios: (1) restructuring with bail-in, no public money and no sovereign default; (2) restructuring with bail-in, no public money and sovereign default; (3) ESM direct recapitalisation following the current guidelines; (4) ESM direct recapitalisation with a lighter version of bail-in than the one currently prescribed (the reason for this will be explained later)[1]. Notice that we do not consider a rescue option “à la Spain”, i.e. with a traditional ESM loan, as this would further increase the Greek debt.

Table 3 – composition of liabilities

Source: RBS and other market research

The impact of bail-in depends very much on the composition of banks’ liabilities (Table 3). A significant share of banks’ liabilities is currently made up of ELA funds, which cannot be haircut. At the aggregate level, central bank liquidity accounted for about 30% of total liabilities the Greek banking system, as of May 2015. At the level of individual institutions, ECB lending was equivalent to 21% of assets in NBG, 37% in both Alpha and Piraeus and 39% in Eurobank. At the system level, household deposits account for 29% of total liabilities and non-financial corporation deposits for 5%. RBS estimates suggest that at least 60% of deposits is below the 100 000-euros threshold. These qualify for depositor protection and should not be touched. Deposits above that threshold could be haircut, although the “depositor preference” introduced in the DGS directive after the Cypriot crisis foresees that uninsured deposits have a higher ranking than claims of other creditors in both insolvency and resolution proceedings. As far as bank debt is concerned, Table 3 show that Greek banks have a very small portion of subordinated debt, whereas the bulk of debt is senior, mostly due to the existence of government guarantees.

Scenario 1: no public money; restructuring without sovereign default

This is a baseline scenario and it allows us to assess how much bail-in would be required to recapitalise the Greek banks under the shock assumption highlighted above, without putting new public money on the table and assuming that the government does not default on its obligations. The latter assumption means that the value of government-guaranteed bonds is preserved, reducing the pool of bondholders over which losses can be spread.

Table 4 – Scenario 1

Source: author’s calculations based on RBS data

The Greek government is cash-strapped, so without financial assistance it would not be able to inject all this capital in the banks. The shortfall would need to be covered by bailing-in private investors. Table 4 shows that with no new public money, a capital shortfall would remain even after a full bail-in of subordinated/other bonds as well as of the senior bonds that are not government guaranteed. Under the more conservative assumption that excludes DTAs from capital, a haircut of uninsured deposits between 6% and 40% would be needed, depending on the bank. Even if DTAs were counted in, Alpha, Piraeus and Eurobank would need at least a 12% haircut on uninsured deposits. The haircut would obviously increase if senior non-guaranteed bonds were not bailed in fully.

Scenario 2: no public money; restructuring; sovereign default

Scenario 2 includes the assumption of no public money but sovereign default. Sovereign default has an impact on the assets side, reducing assets and consequently affecting risk-weighted asset (RWA), which is not considered here for simplicity. On the liability side, sovereign default implies that the government-guaranteed bonds can be haircut. This increases the pool of bondholders on which losses can be spread and makes it possible to fill the capital hole without resorting to bail-in of depositors. In particular, Table 5 shows that after a full bail-in of subordinated/other bonds, the remaining shortfall could be met without touching depositors, even under the most conservative assumption of excluding DTAs from capital. This would require a haircut between 14% and 80% on senior debt, under the most conservative assumption.

Table 5 – scenario 2

Source: author’s calculations based on RBS data

This scenario shows that restructuring would in a way be “easier” under the assumption of sovereign default, because the capital shortfall could be covered without having to haircut the depositors. Default has however very significant direct impact on the asset side and indirect impact on liquidity provision, which could easily result in exit, so it is a very undesirable outcome. Scenario 3 and 4 thus look at whether the shortfall could be filled without default and limiting the haircut need on depositors.

Scenario 3 and 4: ESM direct recapitalisation

ESM direct recapitalisation instrument was created specifically in order to deal with problems in the banking system without passing through the government’s books. This therefore avoids the increase in government debt that would occur with a normal ESM loan (c.f. the Spanish case) and aims to break the sovereign/banking cycle. The instrument has also the great merit of allowing control by the ESM of a large part of the banking system and thereby facilitating the ECB’s secondary mandate of promoting the smooth functioning of the payment system.

There are however two sets of eligibility condition for the banks as well as for the Member States. The requesting ESM Member would have to be unable to provide financial assistance to the beneficiary bank without very serious effects on its own fiscal sustainability. The financial institutions to be recapitalised “are (or are likely to be in the near future) in breach of the capital requirements established by the ECB in its capacity as supervisor and deemed unable to attract sufficient capital from private sources to resolve its capital problems, including via new market investors, shareholders, or an appropriate level of writing-down or conversion of debt" And "the institution is of systemic relevance or poses a serious threat to the financial stability of the euro area as a whole or of its Member States". Greece is in such bad fiscal position that it is certainly unable to provide financial assistance to its banks without serious effects on its fiscal sustainability. As far as the systemic relevance is concerned, the four banks are systemic for Greece (as they represent about 90% of the total Greek banking sector). Letting them fail would also be systemic to the euro area, as it could be the prelude to Grexit, an event that is unprecedented and whose systemic implications (in particular those linked to signalling that the Euro is not irreversible) cannot be foreseen.

In addition, the given Member State is usually expected to contribute to the recapitalisation apart from exceptional cases in which the ESM Member is not able to contribute up-front due to its fiscal position. Invoking this flexibility clause would require mutual agreement.

The Member State contribution can take one of two forms, depending on the situation in the bank:

1. If the institution has insufficient equity to reach the legal minimum Common Equity Tier 1 (CET1) ratio of 4.5%, as established in the Basel III framework/CRD IV/CRR, the requesting ESM Member will be required to make a capital-injection to reach this level before the ESM enters into the capital of the institution.

2. If the institution already meets the above-mentioned capital ratio, the requesting ESM Member will be required to make a capital contribution alongside the ESM, equivalent to 20% of the total amount of the public contribution. In exchange for its own contribution, the ESM would get shares in the bank which it should ideally be able to sell with an upside later on.

Finally, direct recap requires a preliminary bail-in ("Direct recapitalisation by the ESM will only be considered if private capital resources are engaged first"). Until 31 December 2015, a bail-in equal to 8% of total liabilities, including own funds of the beneficiary institution, will be applied. In addition, a contribution from the ESM Member’s national resolution fund will be made up to the 2015 target level. From 1 January 2016, BRRD rules would apply.

Scenario 3: ESM direct recapitalisation with bail-in as in the current guidelines; no default

The current guidelines foresee a required bail-in of 8% of total liabilities including own funds, which would need to be carried out before the ESM can intervene. Table 6 show that meeting this requirement in the case of the Greek banks would require a full haircut on subordinated/other bonds, a full haircut on senior non-guaranteed bonds and still a haircut on uninsured deposit ranging between 12% and 39% for three out of four banks. It is a very tough bail in request, which in fact would already bring all banks above the 4.5% CET1 threshold explained earlier and two of the banks above 8% CET1.

The remaining capital shortfall to reach 8% CET1 would be covered 80% by the ESM and 20% by Greece. The ESM would therefore effectively play a very limited role in this operation, even assuming that the Greek contribution can be waived due to its fiscal situation, as explained above.

Table 6 – Scenario 3

Source: author’s calculations based on RBS data

Scenario 3 shows that the bail-in requirement currently applicable in the context of direct recapitalisation would be very tough. This requirement is problematic for two reasons.

First, it imposes targets similar to those that will apply under BRRD, without the flexibility that exists in BRRD and outside of the general framework that will prevail after 2016. A BRRD bail-in will take place in a context in which banks will be required to maintain (subject to on-going verification by authorities), a percentage of their liabilities in the form of shares, contingent capital and other unsecured liabilities not explicitly excluded from bail-in. In the Greek banks at the moment, a bail-in of 8% of total liabilities would require a very significant haircut on uninsured deposits in a country where a bank run is already happening. It is worth pointing out that the implied haircuts presented in these scenarios are based on an assumptions that 40% of all the outstanding Greek deposits is uninsured. Considering the situation of Greece now and the fact that deposits have been leaking out for months, the remaining pool of uninsured deposits could be smaller and the impact of bail-in on deposits might end up being even larger.

Second, BRRD foresees some exemptions concerning bail-in, which the ESM direct recap does not have at the moment. Article 44(3) of the BRRD directive provides four exceptions, stating that in those cases the resolution authority may exclude or partially exclude certain liabilities from the application of the write-down or conversion powers. One of these exemption is when “the exclusion is strictly necessary and proportionate to avoid giving rise to widespread contagion, in particular as regards eligible deposits held by natural persons and micro, small and medium sized enterprises, which would severely disrupt the functioning of financial markets, including of financial market infrastructures, in a manner that could cause a serious disturbance to the economy of a Member State or of the Union”. This is evidently happening at the moment in Greece, where a full-fledged bank run is being kept contained only because of capital controls (which should unquestionably qualify as a “severe disruption of the functioning of financial markets”).

On top of that, the bail-in requirement currently applicable in an ESM direct recapitalisation is significantly higher than the one set by the European Commission in the amended state aid guidelines (2013), which constitute the official transition framework to BRRD. This framework states that before 2016, only the bail in of junior debt is mandatory before state aid can be granted. ESM direct recap would be akin to an operation of state aid in which part of the injection is done by the ESM directly rather than by the Member States with previously borrowed ESM money. In exchange for this additional risk, the ESM gets more control on the banks (including the possibility to add more institution-specific conditions). It is therefore hard to see why the bail-in requirement in this instance should be higher than it is for a normal State aid operation with an ESM loan.

Scenario 4: ESM direct recapitalisation with bail-in as in the amended State-Aid guidelines

Scenario 3 is really not very different from the case in which the banks are restructured and recapitalised with full bail-in, because the amount of bail-in required in the ESM direct recap guidelines is such that the ESM would play only a minor role. The requirement implies the need for high haircut on deposits, which could have unpredictable consequences in a country where a bank run is underway.

Here I present a scenario in which ESM direct recap is carried out with the bail-in requirement in the amended state aid guidelines, showing that in such a case the ESM intervention makes a more significant difference.

Table 7 shows that after a 100% haircut on subordinated/other non-senior debt, the banks’ CET1 is still below 4.5% under the most conservative assumption of excluding DTAs. Even when DTAs are counted in, Alpha, Piraeus and Eurobank remain undercapitalised. Under the ESM direct recap’s pecking order, Greece needs to bring the banks to 4.5% CET1 before the ESM steps in and take them to 8%.

Under the conservative DTAs assumption, the contribution to reach 4.5% could be substantially bigger than the ESM contribution, for those banks that are less capitalised and that do not have much bail-in-able junior debt. The last rows of Table 7 show the relative share of private sector, ESM and Greece in the recapitalisation of the four banks, highlighting that the requirement to bring the banks at 4.5% CET1 is a heavy one, in absence of much bail-in-able debt. The current construction of ESM direct recapitalisation is such that Greece would effectively end up bearing the largest chunk of the intervention, which shows that this instrument is in fact unfit for fulfilling its original aim of breaking the link between banks and sovereigns. The silver lining is that this contribution could be suspended – by mutual agreement – in light of the fiscal situation of Greece and that compared to a normal recapitalisation operation the impact of Greek debt would be smaller.

Table7 – Scenario 4

Conclusion

Regaining the stability of the Greek financial sector is key at the moment, as a meltdown could lead to Grexit. This may require actions to recapitalise the banks. Europe disposes of an instrument that could allow recapitalisation of the Greek banks with a more limited impact on the Greek debt while at the same time awarding the ESM control over the banking system. This would be crucial to separate banks’ troubles from those of the sovereign and ensure that the banks can be kept alive.

This instrument is the ESM tool for direct recapitalisation, born with the initial aim to break the sovereign-bank vicious cycle and never used as of today. As it currently stands, however, this instrument would require a very significant bail-in of 8% of total liabilities, before the ESM can step in. This requirement has some incongruences and inconsistencies that have been pointed out under Scenario 3.

Meeting this target would imply significant haircut on uninsured deposits, in a country where a depositors’ run in currently underway. The scenarios presented here suggest that the best solution to recapitalise the Greek banks would be to make use of the ESM direct recapitalisation instrument, but limit bail-in to what is currently mandatory under the amended state aid requirement and suspend Greece’s contribution. This would allow the ESM direct recap to make a greater difference. Nevertheless, this example shows how the current design of the ESM direct recapitalisation instrument is unfit for its original purpose of credibly breaking the link between banks and sovereign.

What’s at stake: On June 28, the governor of the Commonwealth territory announced that it would not be able to repay its debt. Puerto Rico has since asked Congress to change the law to make the tools that U.S. municipalities can use to restructure their debt through Chapter 9 available to its territory.

Barry Eichengreen writes that the United States now has its own version of Greece in Puerto Rico. The territory's debts are unsustainable. Public employment and pensions are swollen. Work in the underground economy, where taxes are evaded, is rife. Modern infrastructure is lacking. The commonwealth exports little for an economy of its size. Many of the best and brightest have decamped in search of better opportunities.

Max Ehrenfreund writes that the Commonwealth of Puerto Rico is not a state, but it's been under the control of the United States since the Spanish-American war in 1898.Nick Timiraos writes that Puerto Rico’s problems date to the end of the Cold War, when the U.S. began closing military bases on the island, whose residents have American citizenship but don’t pay federal tax on their local income. The expiration of corporate tax breaks in 2006 prompted an exodus of businesses, throwing the island into a recession. Matt O’Brien writes that Puerto Rico was soon stuck in a vicious circle where the bad economy made people move to the mainland in search of work, the shrinking population left the government with a shrinking tax base to pay for the same amount of spending, and, after borrowing to cover this up, they eventually had to try to close their budget hole with austerity measures—which only made the economy even worse and made even more people leave.

Sovereign default, exit fears and sideshows

Barry Eichengreen writes that, in contrast with Europe, Puerto Rico will be at most a sideshow. One should not underestimate the ability of US politicians to get it wrong. But Puerto Rico will remain only a minor distraction. The US Congress will pass legislation giving Puerto Rico access to American bankruptcy courts. Its debt will be restructured, and all those reckless enough to have lent it money will see their claims radically written down. Once the island's government, relieved of its crushing debt burden, responds with reforms, the US will provide further aid.

Gillian Tett writes that, in theory, as Lawrence Summers says, one resolution would be for the International Monetary Fund to intervene. But it will not, since Puerto Rico is not a sovereign state. Washington could play an IMF-style role if it chose, since Puerto Rico, as a territory, is part of the federal system. But the Obama administration has made it clear it does not wish to intervene. That suggests that the least bad remaining option is to find a third party legal referee to oversee an economic plan that forces the creditors into a compromise. America does have one existing model for this: a Chapter 9 framework that offers bankruptcy protection for public entities. This was used to restructure Detroit’s $18bn debt pile. But since Puerto Rico is a territory, not a city, it is not allowed to use Chapter 9 without a change in US law.

Matt O’Brien writes that Greece and Puerto Rico both borrowed more than they could pay back, both are stuck in deep recessions, but both aren't at risk of getting forced out of their currency unions. Only Greece is. That's because the euro zone doesn't have a banking union yet, so a debt crisis can morph into a financial crisis and then a currency crisis. John Cochrane writes that in a currency union, sovereign debt must be able to default, without shutting down the banks, just as corporations default.

The Krueger report’s mix of reforms, fiscal adjustment and restructuring

Robin Wigglesworth writes that the Krueger report suggests even restructuring the “General Obligation” debt of the Puerto Rican government itself, and no US state has restructured in living memory. The island’s constitution enshrines creditors’ rights to be paid even ahead of pensioners, and hedge funds that make up a big part of Puerto Rico’s bondholders are not going to roll over.

Anne Krueger, Ranjit Teja and Andrew Wolfe write that Puerto Rico needs a comprehensive approach as its problems are interdependent. Fiscal adjustment alone might strengthen confidence in long-term public finances and thereby support demand. But too much fiscal tightening could also depress demand in the near-term and would do nothing to address the supply side problems at the root of Puerto Rico’s growth problem. Similarly, structural reforms alone would still leave large fiscal financing gaps. Hence the need for complementary debt restructuring to avoid an economically harsh and politically unviable cut in the fiscal deficit. A combination of structural reforms, fiscal adjustment, and debt restructuring ensures that all problems are addressed. And, importantly, it shares the costs and benefits of adjustment across all stakeholders.

Anne Krueger, Ranjit Teja and Andrew Wolfe write that debt relief could be obtained through a voluntary exchange of old bonds for new ones with a later/lower debt service profile. To agree to it, bondholders would need to be convinced that the specific reforms on the table are indeed a best use of debt relief, and that – by keeping the government functioning as it phases in organizationally and politically difficult measures – the reform program will increase the expected value of their claims. Negotiations with creditors will doubtlessly be challenging: there is no US precedent for anything of this scale and scope, and there is the added complication of extensive pledging of specific revenue streams to specific debts. But difficult or not, the projections are clear that the issue can no longer be avoided.

Restructuring idiosyncrasies

Nick Timiraos writes that as a commonwealth, it lacks the tools available to U.S. municipalities to restructure their debt through Chapter 9 of the bankruptcy code. A bill introduced in Congress last year would grant the island the ability to allow its public authorities to access Chapter 9 protections, but the bill hasn’t moved anywhere amid resistance from some creditors and conservative Republican lawmakers.

Dara Lind writes that, in 2014, the government of Puerto Rico passed a law allowing public corporations to declare bankruptcy. Creditors were not pleased, and earlier this year, a judge struck down the law because it was trumped by federal law. So without action from Congress, Puerto Rico could end up in a messy situation where individual creditors could sue to get their money back, which could prevent Puerto Rican public sector employees from getting their paychecks. Max Ehrenfreund writes that the laws determining who would get paid first if the island goes bankrupt are ambiguous. That $72 billion includes debts owed to retirees with public pensions as well as to firms on Wall Street that have loaned their client's money to the commonwealth.

Gillian Tett writes that the island’s debt structure is staggeringly complex, since the bonds have been issued by numerous different entities, with varying types of guarantees. These creditors show no desire to co-ordinate; instead, they are threatening to sue each other and the island. Thus the nightmare scenario that now haunts Puerto Rico is not so much that of Greece but Argentina: years of legal limbo, shut out of the capital markets.

Greece sent its proposal to Brussels yesterday, in an attempt to pave the way for the negotiation of a third ESM programme. The package makes significant concessions to the creditors’ position, compared to the previous proposal from the Greek side, including in politically sensitive areas. This raises the important issue of what the reason for holding the referendum in the first place was. Nevertheless, it is well worth examining the proposal in detail.

Primary surplus target

This is the issue on which agreement had been reached already, and the proposal retains the targets that were in the previous version: 1, 2, 3, and 3.5 percent of GDP in 2015, 2016, 2017 and 2018 respectively. What is interesting is that these targets are now in brackets, which means they could be changed before the document is actually approved. The reason for this, is the dismal state of the Greek economy: the deterioration since the beginning of the year has been such that even the 1% target for this year would require the supplementary package of fiscal measures outlined in the document. This package is not changed much compared to the version submitted before capital controls were introduced, but controls are likely to have worsened the situation even further, making these assumptions optimistic. It is worth reminding that July is a key month for revenue formation in Greece, as we pointed out earlier. This is hardly a typical July.

Compensating measures

The fiscal package includes two compensating measures to deal with potential shortfalls (which are likely, as highlighted in the previous point). The increase in corporate income tax rate from 26% to 28% remains unchanged, but the rate could be increased by an additional percentage point (i.e. from 28% to 29%), in case of a shortfall. A second compensating measure in case of a worse than expected fiscal position would be the increase in the tax on rental income. For annual rental incomes below €12,000 the rate would increase to 15% (from 11%), creating an additional revenue of €160 million. For annual incomes above €12,000 it would hit 35% (up from 33%) with an additional revenue of €40 million.

Military spending

The document also sees €100 million additional cuts to military expenditure, which would bring the total cuts to €300 million (100 in 2015 and 200 in 2016). This is closer to the 400mn the creditors were asking.

VAT System

The Greek side converges on the 1% revenue target asked by creditors, with new legislation to be adopted now and effective as of 1 July 2015. The rates will be 23%, 13% and a reduced 6% for pharmaceuticals, books and theater tickets. The Greek proposal agrees to the creditors’ demand to move processed food into the 23 % bracket, while keeping energy and hotels in the 13% band. It also foresees the elimination of the discounts on islands - a highly debated issue in negotiations and a politically difficult one for the Greek side. However, the document says that the elimination will start with the islands with higher incomes and which are the most popular tourist destinations, excluding the most remote ones. The new VAT rates on hotels and islands will be implemented from October 2015, but clarification will likely be asked on this specific point.

Pensions

On pensions, the text proposes a compromise. The 2012 pension reform legislation will be implemented in October 2015, with a set of prior actions from July. The Greek side concedes to increase retirement age by 2022, as asked by creditors, while the Greek side initially proposed 2036 and later offered 2025. On the EKAS “solidarity grant”, which provides top-ups for poor pensioners, and has hugely contentious in previous negotiations, the proposal offers a middle ground. Creditors asked initially for the phase out of this grant by 2017; this proposal sets 2019 and it delays the phase out for the top 20% of beneficiaries to March 2016, rather than do it immediately as the creditor asked. This is a reasonable proposal and the delay could perhaps allow this cut to be somewhat acceptable, so long as the third programme includes measures targeted at the humanitarian crisis as this government has been asking since the beginning.

A viable compromise?

Overall, this proposal looks like a good attempt to create the ground for compromise, as it moves closer to the creditors on significant issues. However, it remains uncertain whether it solves the issue in economic terms.

This proposal as it stands does not include any mention of debt relief. This is not surprising. After all, the last review of the current programme is not yet closed and this package of prior actions had been initially conceived to extend the current programme by some months, before the request for a new loan was sent to the ESM. Merkel suggested this week that commitments for a new multi-year programme would need to go beyond this, which leaves an element of uncertainty as to what this proposal can actually achieve.

The Greek government could have signed a similar deal before the referendum, without having to introduce capital controls and hurt the economy even more. It said it could not without getting a sign from the people that it supported this agreement. The Greek people overwhelmingly rejected it. The current agreement concedes even more to the creditors on several politically sensitive issues without even a mention of debt relief. Bluntly speaking, it seems ex post that the only result of last Sunday's exercise of democracy has been to show what was obvious: in a monetary union made of 19 democracies, a referendum in one country cannot force the others to change their minds.

There were reports yesterday of an “explanatory memorandum” sent to the Greek Parliament together with this document (and only available in Greek), saying that the final agreement will include the commitment from lenders to negotiate with Greece over making the Greek debt sustainable after 2022. This however does not appear in any of the documents sent to Brussels and published. If such clear understanding between Greece and the creditors exists behind closed doors, it should be made explicitly public. Tsipras needs some solid and credible commitment from Europe to talk seriously of debt relief, so that this deal can be justified before the parliament and the Greek people as a necessary bridge to that discussion. He needs it now. Greece with this package is showing efforts to come closer to the creditors' position and signs of goodwill to embark on what its finance minister defines as "the Herculean task" of fundamental reform. It is high time for the creditors to move too, from whispering to making bold and credible statemen

G-Day is coming: Greece’s future will be decided on Sunday. The government has requested a new €53.5bn bailout loan, promising in return structural reforms and fiscal austerity. The referendum result should make it more difficult for the Greek government to agree to conditions similar to those that were voted down. Meanwhile it gives a reason for official lenders to let Greece leave the euro area if a new agreement is not reached.

Nevertheless, I still regard an agreement as likely and expect the Greek government to accept conditions in exchange for some easing of the debt burden - perhaps through extended maturities and grace periods, deferred and slightly lowered interest rates, or possible GDP-indexing. The agreement should focus on growth-enhancing structural reforms and limiting corruption and tax evasion. A lasting and implemented agreement will likely restart growth. While the adjustment of other EU countries with similarities to Greece (Portugal, Spain and the Baltics) was painful, all of these countries have returned to growth and job creation. Even Greece started to grow in 2014 and new jobs were created in every quarter of that year, although this badly reversed in the past six months. Still, even if an agreement is reached, lifting capital controls will take a long time. It cannot happen until trust in the banks is restored, which depends on the implementation of the programme, disbursement of tranches and the restoration of normal cooperation between the Greek government and its lenders. In Cyprus, controls were promised for a few weeks but lasted for two years.

Lack of an agreement on Sunday will lead to Grexit, which would be extremely painful for Greece: a further major fall in Greek GDP and employment, and the loss of savings. The resulting lower tax revenues would necessitate further fiscal austerity even if the government stops completely servicing public debt. For the EU and the IMF an exit would likely mean writing down official loans to Greece and ECB lending to Greek banks. A Grexit would make the remaining euro area more vulnerable. Whenever the public finances of another government would come under stress, markets may bet on that country also exiting the euro area.

So, I keep my fingers crossed for an agreement and its implementation.

After putting up with a bear market for years, the Chinese stock market started to rally last autumn against the backdrop of a new easing cycle by the People’s Bank of China (PBoC). As if this were not enough in a largely liquidity driven market, the PBoC promoted stock market financing by easing margin credit conditions. As a result, the Shanghai stock market skyrocketed for about nine months until it suddenly moved into red to end up with a huge sell-off, which has wiped out one third of China’s stock market value.

The key questions I will address in this note are why all of this is happening and why we should care.

Why did we have a bull market to start with?

The stock market rally was clearly sponsored by the Chinese government. It all started with the widely trumpeted announcement of the Shanghai - Hong Kong Stock Connect last year to help Chinese corporates raise equity beyond the Mainland, with the announcement of a huge number of IPOs following suite. The underlying reason for the Chinese to push the stock market at that time was that Chinese banks and corporations needed a venue to raise equity after an era of excessive leveraging. Yet neither the Shanghai nor the Hong Kong stock market was well placed after years in a bear market.

The need for Chinese corporations and banks to avail themselves of fresh equity cannot be underestimated. On the one hand, corporate debt has grown sixfold from 2005 levels. On the other hand, Chinese banks are not only heavily exposed to these corporates, being still their main source of financing, but also to local governments whose huge borrowing from banks is starting to be restructured. To make a long story short, China’s governments needed a bull stock market to transfer part of the cost of cleaning up its corporates’ and banks’ balance sheets from the state to private investors, including foreigners. The PBoC danced to the Government’s tune, easing monetary policy since November last year. This was done through several interest rate cuts and by lowering the liquidity ratio requirements. The problem with all of this liquidity is that it only fueled additional leveraging, including for gambling on the stock market. The demand for stocks was abundant for two main reasons: the real estate market was no longer a venue for quick gains and shadow banking is less accessible than before - not to talk about the even lower interest rates offered on bank deposits after monetary easing.

The sudden collapse of the Chinese stock market had two triggers. First, the was a wave of profit taking after the Shanghai benchmark index broke through 5 000 in early June and doubts emerged about further easing from the PBoC. At that very same moment, China’s securities regulator announced measures to cool down the market, which amounted to banning brokerage firms from providing unregulated margin funding to investors. This was more of a shock to the system than one might imagine, as margin financing in China is much larger than in other stock markets.

Chinese authorities have clearly been taken off-guard (perhaps they were too concentrated on watching the Greek drama and missed their own) until the situation worsened later last week. They then frantically announced draconian measures to stop the slide. Such measures included trading halts for as much as half of China’s stock market and cancelling all of the IPOs which were in the pipeline. Another important measure was the creation of a Financial Stabilization Fund through which Chinese brokerages would intervene until the Shanghai stock market could regain a level close to one before the sell-off. The latter measure could well be behind the strong gains we have seen in China’s stock market during the last two days.

Why care?

China is clearly undergoing a systemic event which will have consequences for both China and its partners.

The most immediate effect will be on China’s corporates and banks, who will not be able to access the equity market for quite some time. This might be an urgent problem for those corporations which had relied on IPO plans. Chinese banks will also be affected indirectly in as far as they will need to support Chinese corporates in these difficult times.

Beyond these direct effects, it seems clear that confidence in China is being severely affected by this event. Consumption and private investment will sure be hit by such a spike of uncertainty. Given that the wealth effect is relatively limited in China (households have large savings and are not leveraged), the largest impact will probably be on private investment.

As China’s growth projections are revised downward, others will feel the pinch as well. Commodity markets and stock markets in the rest of Asia have been the first to react but we should see more coming in terms of revised growth projections in the rest of Asia. Once Europe wakes up from the Greek nightmare, corporations heavily exposed to China – of which there are, many especially in Germany – may need to revise their revenue projections and perhaps their investment plans. This argument can also be extended to US corporates exposed to China. The impact has already been seen in global commodity prices. Both oil and metal prices have already been severely affected, and global risk aversion is closely following China’s stock market collapse. On both sides, more price falls could come once analysts start revising projections for the Chinese economy downward.

On this point, it is obviously too early to know what the impact on the economy will be but it is important to realise that, even if the situation stabilises, at least one percentage point will be shaved from China’s growth rate for 2015. The main damage will be to the financial sector, security brokerages and banks. This also could already account for that one percentage reduction in growth this year, or more so if we consider that the booming stock market has added more than half a percentage point to growth in the first quarter of 2015. This is, therefore, just the start, and we should be presuming a larger reduction in GDP growth unless the government implements another massive intervention like the 2008-09 fiscal stimulus package. However, this would only be a short-term relief to China’s long term issues anyway.

However, the most important point is how all of this may affect China’s internal reform process and, thereby, China’s role in the global economy. The drastic measures taken by the Chinese government seem to indicate that financial – and thereby social – stability is more important than pushing further towards a more market-based economy. The pro-market reforms that Xi Jinping announced at the Plenum in November 2013 look far from where we are today. Half of the stock market is out of action and the Chinese authorities - or their allies – are artificially propping up stock market values in order to survive what is not only a stock market collapse but a confidence crisis.

Following on from our previous blogs, we take another look at the intra-day developments in financial markets after yesterday’s European Council meeting to discuss the urgent situation in Greece. While the general picture remains broadly the same as before, developments in the Portuguese 10-year yield are worth watching.

Figure 1: Intra-day developments in sovereign yields (%)

Spain, Italy and Portugal all had initial increases in yields following the the news that Greece would go to the polls (29/06). Yields have been more or less stable with some variance since then, however Portugal is beginning to diverge from the other two in the periphery group, starting some time yesterday or the day before. This could be a sign markets are slightly more nervous about the possibility of contagion from a Grexit scenario in Portugal than in Spain or Italy, however, these developments are still very mild in their historial context.

Germany and France have seen their yields fall over the last couple of days, undoing the slight up-tick we saw at the end of last week.

If we look at the Periphery spreads (against Germany) we can see that all have experienced increases around the referendum announcement and outcome. Portugal has continued to drift upwards while Spain and Italy are relatively more rooted at the higher level.

Figure 2: Stock Market Movements

The stock markets appear to be a lot more downbeat than the bond markets. The national indicies of Germany, France and Spain are all continuing to slide lower. At the

On Sunday, with a sizeable majority, the Greek people voted down the proposals of the country’s official lenders. What’s next? We see three main options and will describe the pros and cons of each in more detail:

· Grexit

· A new financial assistance programme for Greece

· Default or debt write-down inside the euro area coupled with external bank support and control

The choice will ultimately be political and we do not wish to speculate about the probabilities of these scenarios. However, a lot of trust was eroded over the last six months, which could make finding an appropriate solution very difficult. Instead of discussing politics, we want to discuss the economic implications of these three scenarios and their advantages and disadvantages.

One option is Grexit. There is no legal way for a country to leave the euro area, nor is there a way to expel a country from the euro area. However, economic necessity could make this necessary, which could lead to a de facto exit and ultimately result in a change in the EU Treaty to make exit legally possible. The key issue here is what happens to banks. If banks run out of cash, people’s cash reserves may run out too and they will find it difficult to buy basic goods such as food. Companies will find it difficult to pay their suppliers, which could increase corporate bankruptcies further. Sooner or later imports will stop (as importers will be unable to pay), which would further disrupt the economy and hurt people. Tax revenues will collapse and the government will not be able to pay wages and pensions. A new means of payment will have to be introduced to keep the economy going.

In our assessment, Grexit would lead to the largest financial losses for creditors, as most of the official financial assistance as well as the entire ECB and Bank of Greece’ Emergency Liquidity Assistance (ELA) liquidity would probably be lost. In addition, a Grexit might increase future financial stability risks to the euro area whenever another euro-area country comes under pressure from the markets. The benefits of Grexit for Greece in terms of regaining competitiveness and increasing employment may be less significant than some commentators like Paul Krugman or Hans-Werner Sinn argue. In fact, we have argued (here and here) that the reason for weak Greek export performance was not high wages, but other factors such as rigid product markets, the complexity of regulatory procedures, weak institutions, a political system that prevents real change and guarantees the privileges of the few, etc.

An argument often voiced in favour of Grexit is that it would establish the principle that countries cannot break the rules and afterwards be rewarded with unconditional debt relief. A problem with this argument, however, is that it puts all the blame on Greece for the failure of the financial adjustment programmes. In our view the responsibility has to be shared between Greece and its lenders, and Greece has paid a price in terms of employment and income. Another argument favouring Grexit would be that Greece will not be able to extract any resources from the rest of the euro area in the future. Grexit would thus be a clear break, but a costly one with several unknown consequences. It would certainly leave the current European leadership quite a political legacy.

A second option is a new financial assistance programme for Greece. In fact, the Greek government submitted a letter to euro-area partners on 30 June requesting a new financial assistance programme to repay the ECB and the IMF, yet trust has eroded so much that the willingness of euro-area partners to lend new money to Greece is severely reduced.

The outcome of a new financial assistance programme would largely depend on its design. It could lead to growth: indeed, while the adjustment of other EU countries with some similarities to Greece (such as Portugal, Spain and the Baltics) was painful, all of these countries returned to growth and job creation. Even Greece started to grow in 2014 and new jobs were created. Any new agreement may focus on growth-enhancing structural reforms and limiting corruption and tax evasion, while offering a lower fiscal adjustment demand.

The question of dealing with the debt level would remain on the table. We believe that one should agree on a deal that would index debt to GDP. When nominal GDP growth is high, there is no reason to provide any debt relief. When nominal GDP growth is very low, debt relief will be inevitable under any scenario. Such a deal could bring important planning certainty and would make investment and growth more likely.

More importantly, Greece would continue to be subject to a relatively tight budget constraint and programme monitoring. Yet the past five years have demonstrated that cooperation between Greece and its official lenders is extremely difficult. A new financial assistance programme may bring the spectre of another series of disappointments at both sides of the table.

A third option is a default or debt write-down coupled with bank support to keep Greece in the euro area. Similarly to the suggestion of Willem Buiter, euro-area partners may conclude that there is no way to find an agreement that Greece will consistently honour, yet they may prefer to keep Greece inside the euro area. For the latter to happen, Greek banks would need to be kept afloat. This in turn will require support from the rest of the euro area in one form or another. The most likely form of that support would be direct recapitalisation by the European Stability mechanism (ESM), leading to ESM ownership of the Greek banks. The ECB should then continue to provide liquidity to banks and capital controls would be gradually lifted.

The key question in this third scenario is whether one can enforce a hard budget constraint on Greece. This could in principle be achieved by two means. First, Greek banks should be prohibited to finance the government, both under ESM ownership and after the ESM has sold its capital injections in later years. Second, any new financial assistance programme for Greece should be strictly excluded ex ante. Thus the Greek government would need to convince markets to finance any potential deficit under these circumstances. Even if any future Greek government were to default on its market, it would not impact the Greek banking sector directly. In practice, it may be more difficult to enforce a hard budget constraint in this scenario, especially if the Greek government chose to circumvent the rules by imposing losses on the banks through other legislation (e.g. changes in insolvency laws).

The absence of a financial assistance programme would imply that micro-managing the Greek crisis by official creditors is over. This would therefore free Greece and its official creditors from the difficult and apparently unproductive day-to-day cooperation. It would give the freedom to the Greek government and parliament to design and implement their desired policies (at least within the EU’s economic governance framework). However, so far we have not yet seen a sufficient proposal from the Greek government to tackle the major weaknesses of the Greek economy, such as tax evasion, corruption, an ineffective legal system and insufficient competition in product markets, so it is not sure how wisely this freedom would be used. For euro-area partners, this solution would require a complete change in their approach to managing sovereign distresses in the euro area, in addition major losses on their lending to Greece and new support to Greek banks.

In our assessment all three options are problematic. Being in a monetary union with a partner that you do not trust is ultimately unsustainable. But Grexit would be a collective political failure with unknown financial, economic and social risks. A new programme will mean negotiations with Greece for many more years. Meanwhile, a large-scale debt write-down and direct European recapitalisation of banks would be an immense change in the euro-area sovereign distress framework, with wide-ranging consequences including a possible loss of credibility for the no-bail-out clause. Choosing the least political evil will be the main challenge for today’s Eurogroup meeting and Euro Summit. History teaches us that monetary unions can break up, that countries can go bust and that countries can free-ride on others. However, history also teaches us that monetary unions are typically only sustainable if its members face hard budget constraints – enforcing these constraints is a key challenge in the historical creation of monetary unions.

A clear majority of Greek citizens has decided to decline the creditors’ proposal that was on the table on June 25. This result should not be over-interpreted and should be simply taken as it is, a clear NO to the policies that have been implemented in Greece over the last 5 years and that have failed to avoid a free fall of GDP 25% and a dramatic increase of unemployment to 25%. It should absolutely not been seen as a NO to euro membership, as Greeks have reaffirmed without any doubt their willingness to stay in the Eurozone in all polls conducted over the last few weeks.

European policy makers will have some historical decisions to take this week. Even though some of them have tried to re-frame the referendum as an in-out vote last week to push Greek citizens into voting yes, this was never the question that was asked to the Greeks. The European partners of Greece should recognize this and be ready to negotiate a new ESM programme with Mr. Tsipras’ government, who has been given a clear mandate to continue negotiating for a better deal than the one that was on the table on June 25.

Signalling to the ECB that they are willing to reach a deal quickly will be extremely important. In a first phase, this will allow the ECB to at least maintain the Emergency Liquidity Assistance (ELA) to Greek banks at its current level. The ECB’s Governing Council will meet on Monday to decide what they want to do with the ELA. Withdrawing the money lent to Greek banks to replace the massive outflows of deposits that have been taking place over the last few months would result in the bankruptcy of the banking sector and would force the Greek authorities to issue a new currency to recapitalise their banking sector, resulting de facto in the exit of Greece from the monetary union. This would be a major political decision that should not be taken by unelected central bankers before Tuesday’s summit. It is therefore in the duty of the European governments to avoid that by signalling clearly to the ECB that they are ready to reach a deal. In a second phase, advancing quickly in the negotiations and signalling it to the ECB will allow the Governing Council to start raising the ELA ceiling again to play fully its role of Lender of Last Resort. Given the already limited buffer of cash of Greek banks when ELA was frozen, they could run out of cash quickly, even with the current cash withdrawal limits in place, so the increase of the ELA ceiling should take place as soon as possible.

Allowing or, even worse, forcing Greece to leave the Eurozone would be a terrible and irreversible decision. This would be dramatic for Greek citizens in the short-term as it would lead to more suffering resulting from a further collapse in GDP and increase in the unemployment rate. But this would also be dramatic for the rest of the Eurozone as this would definitely show that the euro is a reversible currency and that the promise of the ECB to “do whatever it takes” to preserve the integrity of the monetary union cannot be taken seriously.

It will be difficult, but there is no time to lose now. The creditors of Greece will have to show very quickly that they are ready to compromise, that they are able to be magnanimous and to forget the often divisive rhetoric that have been used by the Greek government on the campaign trail over the last week. By doing that, they will show that they take into account the result of a democratic vote, even if it comes from a small country at the edge of the Union. For their part, even if they have just obtained a big political victory, Mr. Tsipras and his government, will have to be humble and show that they can regain their partners’ trust by finally proposing serious reforms compatible with their platform (e.g. on the judicial system, on corruption, on tax evasion, and on the role of the oligarchy) and with the renewed mandate given to them by the Greek people on Sunday, in order to put the Greek economy and society back on track.

What’s at stake: For the past few months, the Fed has been in a "wait-and-see" mode to assess the strength of the US recovery. In particular, it has been waiting for signs that employment gains translate into wage pressures before beginning its tightening cycle. Although wage gains remain useful to assess the amount of slack in the labor market, the connection between wage and price inflation appears less mechanical than in the past.

Wage-based explanations of inflation dynamics

Yash Mehra writes that for gauging inflationary pressures, many policymakers and financial market analysts pay close attention to the behavior of wages. It is widely believed that if wage costs rise faster than productivity, the price level may rise as firms pass forward increased wage costs in the form of higher product prices. Hence changes in productivity-adjusted wages are believed to be a leading indicator of future inflation. Tim Duy writes that attention for Thursday’s employment report will not be on the headline employment number, but on the wage numbers.

Ekaterina Peneva and Jeremy Rudd write that wage-based explanations of inflation dynamics have seen increased prominence of late, as a number of observers have sought to use developments in the labor market (e.g. nominal downward rigidity, duration composition of unemployment) to explain why price inflation did not decline by as much as conventional models would have predicted following the 2007–2009 recession (the so-called “missing disinflation” puzzle).

Tracking wage growth

Kevin Drum writes that there are various way of tracking wage growth (with or without benefits, employer survey vs. worker survey, nonsupervisory vs. everyone, etc.).

Martin Feldstein writes that average hourly earnings in May were 2.3% higher than in May 2014. Since the beginning of this year, hourly earnings are up 3.3%, and in May alone rose at a 3.8% rate. Average compensation per hour rose just 1.1% from 2012 to 2013, but then increased at a 2.6% rate from 2013 to 2014, and at 3.3% in the first quarter of 2015. Real Time Economics notes that employer costs for employee compensation jumped 4.9% from a year earlier in March, the second consecutive increase at that relatively robust level. The Labor Department’s employment cost index. RTE points out that some measures have diverged potentially underlying permanent shifts in the structure of the workforce, with faster-growing occupations seeing stronger wage gains.

Economists at the Atlanta Fed write that the current pace of nominal hourly wage growth is similar to that seen during the labor market recovery of 2003–04 and about a percentage point below the pace experienced during 2006–07, which was the peak of the last business cycle.

Nick Bunker writes that the level of compensation growth is below the level we’d expect. Assuming a 1.5 percent labor productivity growth rate and 2 percent annual inflation – the target inflation rate of the Federal Reserve—then adequate nominal wage growth is at least 3.5 percent. Wage growth for production and non-supervisory workers has only hit that target over the past 25 years when the prime-age employment ratio was at least 79 percent six months prior. How long will it take to hit that 79 percent target? If we assume the employment ratio continues to grow at the rate it has been over the past year, then it will hit that target in 27 months, or around September 2017. And then six months later, in March 2018 we would expect to see healthy wage growth.

The pass-through of labor costs to price inflation

Martin Feldstein writes that these wage increases will soon show up in higher price inflation. The link between wages and prices is currently being offset by the sharp decline in the price of oil and gasoline relative to a year ago, and by the strengthening of the dollar relative to other currencies. But, as these factors’ impact on the overall price level diminishes, the inflation rate will rise more rapidly.

Ekaterina Peneva and Jeremy Rudd write that many formal and informal descriptions of inflation dynamics assign an important explicit or implicit role to labor costs. Intuitively, labor compensation should be a key determinant of firms’ pricing behavior as, in the aggregate, it represents about two-thirds of firms’ total costs of production. More formally, economic theory suggests that increases in labor costs in excess of productivity gains should put upward pressure on prices; hence, many models assumed that prices are determined as a markup over unit labor costs.

Yash Mehra writes that in the short run, productivity-adjusted wage growth and inflation appear to comove closely only over a subperiod that begins in the mid 1960s and ends in the early 1980s. This subperiod is the one during which inflation steadily accelerated. In the remaining subperiods, there does not appear to be much strong comovement between wage growth and inflation, at least in the short run.

Carola Binder writes that recent research from Fed economists fails to find an important role for labor costs in driving inflation movements, casting doubts on wage-based explanations of inflation dynamics in recent years. In 1975 and 1985, a rise in labor cost growth was followed by a rise in core inflation, but in recent decades, both before and after the Great Recession, there is no such response.

Wage, productivity and GDP growth

John Cochrane writes that the long-delayed "middle class" (real) wage rise is here. In addition to worries of cost-push inflation, we often hear that real wages have not kept up with productivity. So, maybe we should cheer – rising real wages means wages finally catch up with productivity, and do not signal inflation. YiLi Chien and Maria A. Arias write that, over the past 42 years, the real hourly wage rate has increased by half the increase in per capita GDP. Moreover, real wages grew very little or even experienced negative growth for a long period until the mid-1990s.

GW. First of all, it is a rejection of the creditors' offer that was on the table one week ago. We will see new discussions now. However, it will not be easy to come to substantive discussions of a third programme. To start formal negotiations, the Bundestag and other parliaments have to agree. The political willingness for this has lessened dramatically after the no vote.

Q. Will the new deal be better or worse than the old or will we even see Grexit?

GW. Grexit is a real possibility. It would be very costly for Greece and for the entire euro area. But I would not exclude another round of negotiations during which banks remain subject to capital controls. The resulting deal may be slightly more favourable to Greece but I expect creditors to be reluctant because they really feel that they are being held to ransom.

Q. What would be the best outcome?

GW. Overall, the best outcome would be a real deal with less austerity but serious reforms in Greece. This is still possible and it would require real leadership in Greece and in other euro-area countries. Creditors should understand that generosity is in their interest because Grexit would be more costly. But creditors should not compromise on demanding structural reforms. Syriza needs to deliver a transformative programme for Greece that ensures competition, limits corruption and ensures fair taxation.

On July 2, the IMF released its analysis of whether Greek debt was sustainable or not. The report said that Greek debt was not sustainable and deep debt relief along with substantial new financing were needed to stabilize Greece. In reaching this new assessment, the IMF stated it had learned many lessons. Among them: Greeks would not take adequate structural reforms to spur growth, they would not sell enough of their assets to repay their debt, and they were unable to undertake sufficient fiscal austerity. That left no choice but to grant Greece greater debt relief and to provide new financing to tide Greece over till it could stand on its own feet. The relief, the IMF, says must be provided by European creditors while the IMF is repaid in whole.

The IMF’s report is important because it reveals that the creditors negotiated with Greece in bad faith. For months, a haze was allowed to settle over the question of Greek debt sustainability. The timing of the report’s release—on the eve of a historic Greek referendum, well after the technical negotiations have broken down—suggests that there was no intention to allow a sober analysis of the Greek debt burden. Paul Taylor of Reuters tells us that the European authorities worked hard to suppress it and Landon Thomas of the New York Times reports that, until a few days ago, the IMF had played along.

As a result, the entire burden of adjustment was to fall on the Greeks before any debt reduction could even be contemplated. This conclusion was based on indefensible economic logic and the absence of the IMF’s debt sustainability analysis intentionally biased the negotiations.

As an international organization responsible for global financial stability, it is the IMF’s role to explain clearly and honestly the economic parameters of a bailout negotiation. The Greeks, many said, benefited from low interest rates and repayments stretched out over many years. Therefore, no debt relief was needed. But, of course, as the IMF now makes clear, if a country has to repay about 4 percent of its income each year over the next 40 years and that country has poor growth prospects precisely because repaying that debt will lower growth, then debt is not sustainable. If this report had been made public earlier, the tone of the public debate and the media’s boorish stereotyping of Greeks and its government would have been balanced by greater clarity on the Greek position.

But the problem with the IMF report is much more serious. Its claims to having learned lessons from the past years are as self-serving as its call on other creditors to provide the debt relief. The report insistently points at the Greek failings but fails to ask if the creditors misdiagnosed the Greek patient and continued to damage Greek economic recovery. Protected by the authority and respect that the IMF commands, it is easy to lay the blame on the Greeks whose rebuttals are treated as more hysterical outbursts of an (ultra) “radical” government.

The creditors’ serial errors are well documented, including by the staff of the IMF. Continuing deliberately to suppress past errors is an act of bad faith but continuing to repeat those errors in making future projections of the Greek debt burden is a willful abuse of the trust that the international community has placed in an organization set up to serve the best interests of all nations. If the IMF’s latest numbers are properly reconstructed, the Greek debt burden is much greater than portrayed—and the policy measures proposed to reduce that burden will make matters worse.

To see this, we must go back to a lesson that American economist Irving Fisher taught in 1933. He says—in italicized words—on page 344 that “the more debtors pay, the more they owe.” That pathological condition arises in the midst of Great Depressions, such as the United States in the 1930s and Greece in the last 5 years.

Here is how this principle applies today to Greece. Recall that prices in Greece have been falling for about two years now. Since debt repayment obligations do not change when businesses sell at lower prices or when wages fall, businesses and households struggle to repay their debt in that deflationary environment. Investment and consumption are held back, the government receives less revenue, making its debt repayment harder. If fiscal austerity is imposed in such a deflationary setting, prices and wages are forced down faster, making debt repayment even harder. This is Fisher’s debt-deflation cycle. Greece is in a debt-deflation cycle. It is the medical equivalent of a trauma patient: the blood flow does not stop on its own and, in such a condition, austerity is like asking the patient to run around the block to demonstrate good faith.

The IMF’s latest numbers bear out this diagnosis. In November 2012, the IMF tentatively concluded that Greek debt was borderline sustainable if it would undertake austerity to reduce its debt burden and structural reforms to spur growth. The primary surplus (the budget surplus without interest payments) was to rise from -1½ percent in 2012 to 4½ by 2016—an extraordinary additional austerity on top of the extraordinary austerity that had already been undertaken since 2010. The Greek government actually delivered on the austerity through 2014, bringing the primary budget in balance, as per the proposed timeline.

But look what happened along the way—and this is the debt deflation cycle. In 2012, prices were expected to be broadly stable over the coming years. Instead, prices fell by over 5 percent just in 2013 and 2014. True, it is important for Greek wages and prices to eventually fall. But because of the Irving Fisher theorem, when prices fall, the debt burden increases. To reduce the debt burden, Fisher says, not only must austerity stop, but the economy must be “reflated.” He emphasizes that it was President Franklin D. Roosevelt’s policy of reflation that ultimately stopped the Great Depression. In an analogy similar to the trauma patient, Fisher says that when tipped beyond a point, the boat continues to tilt further until it has capsized. In a deflationary economy, the bankruptcies and distress can go on in a vicious spiral for years.

This is why the further austerity, while viewed as an evident necessity by many, is counterproductive in an economic depression. The IMF’s latest research makes this clear, here and here. That research is just a gentler restatement of Fisher’s insights.

But disregarding its own research, the IMF’s debt sustainability report says that because the Greeks are incapable of delivering 4½ percent primary surplus, they should reach just up to 3½ percent. This is intended to be a concession. Economic growth, the IMF insists, will rise to 2 percent in 2016 and then to 3 percent in 2017 and 2018; importantly, prices will start rising again by between 1 and 1½ percent a year.

These forecasts are fictitious. What is the evidence? The evidence comes from Greece. The November 2012 analysis, refusing to learn the lessons from the previous two years, proved incorrect because it failed to recognize the inexorable interaction of deflation, austerity, and debt. The lesson has still not been learned. The latest report repeats the same analysis with no explanation why the dynamics have changed. Neither is there reason to think that the global economy will provide a boost. The United States is muddling along with its weak recovery. Crucially, China is slowing down, rendering world trade anemic. It would be foolish to expect a miraculous source of external growth to lift Greece or Europe. Hence for Greece to stabilize and grow, requires maintaining a primary surplus of 0.5 percent of GDP, and that requires more debt relief than the IMF proposes.

This is why the IMF’s latest report is disingenuous. The report says that growth in Greece has failed to materialize because Greeks are incapable of undertaking sustained structural reforms. There is so much that is wrong with that statement. First, my colleague Zsolt Darvas of Bruegel argues persuasively that the Greeks have, in fact, undertaken significant structural reform. He notes that the “Doing Business” index has improved materially and labor markets are now more flexible than in Germany. Second, the IMF had set unrealistically high expectations of structural reforms: productivity was to jump from the lowest in the euro area to among the highest in a short period of time and labor participation rates were to jump to the German level. Again, the IMF’s own research department cautions that the dividends from structural reforms are weak and take time to work their way through (see box 3.5 in this link). The debt-deflation cycle works immediately. If it has taken decades for Greece to reach its low efficiency levels, it was irresponsible to assume that early reforms would turn it around in a few years. Finally, when an economy spirals down in a debt-deflation cycle, demand falls and that, in itself, will show up in the less productive use of resources. So, it is even possible that productivity has increased more but is being drowned by shrinking demand.

We may not like the conclusion, but it is quite simple. Greece has not grown and prices have fallen because that was to be expected when persistent austerity is laid on top of an unsustainable debt. The debt-deflation spiral always outpaces the returns from structural reforms. As certainly as these things can be predicted, on the path set out by the creditors, the stakes will continue to be escalated: the debt-to-GDP ratio will continue to rise, the calls for more austerity will grow, and, as the pattern repeats, more debt relief will needed.

So we arrive to the present. The IMF looks back at its diagnosis in November 2012 and says, the Greeks did not follow our advice; it is no surprise that they are in a mess and they need more debt relief. The truth is that the Greeks are in a mess precisely because they followed the IMF’s austerity advice and because the promised elixir of structural reforms was illusory.

And the double indignity is that the IMF now wants the Greeks to do more austerity in the midst of a debt-deflation cycle because it chooses to misread the evidence of the past years. If that advice is, in fact, followed, it is nearly certain that the Greek debt burden will be greater in two years than it is now.

We may cast a moral and political spin on these facts. Indeed, it is understandable that political considerations will play a central role in the European dialogue. But the economic logic is relentless. And the IMF’s role—its only role—is to render the economic logic transparent for informed decision making. In disregard of generations of fine IMF economists and research, the IMF has engaged in its own moral posturing to retrieve its money and hide its failures.

To be clear, the argument is not that more debt relief be promised in exchange for more austerity now. The argument is that debt relief is needed now—more than the IMF suggests—to prevent the need for even more debt relief later. It is as much in the creditors’ interest to change course as it is in the Greek interest. Once that premise is accepted, then within that basic framework there is much that the Greeks can do to improve their lot. But such is the momentum, the politics will almost surely subordinate the economic logic. That would be a mistake. At what is surely a pivotal moment in European and global history, at least the facts must be laid out transparently.

The decision by the prime minister to call a referendum leaves the Greek citizens with a stark choice. The core of the question is whether Greek citizens will be ready or not to accept that in a monetary union financial assistance and solidarity are only extended if – in turn –the recipient accepts jointly agreed conditions. This is the core of the debate of the last months. It is this principle that the creditors will not be ready to give up – also because of their conviction, that a monetary union requires binding commitments and constraining institutions.

A “no” will mean that no other euro area government will want to justify any further assistance to Greece to its electorate. Nor would the ECB think it had the mandate to support Greece with additional ELA credits. A “yes” will lead to new negotiations. In my reading, the political will to improve the conditions for the Greek citizens by providing an investment programme as well as ease the debt burden has increased. However, it is clear that creditors will continue to demand a tough programme with still high primary surpluses, but also significant efforts to lower economic rents, fight corruption, improve the public administration and work towards a fairer tax system.

A “yes” would give the prospect of staying in the euro area but conditions will not be easy. A “no” will result in Grexit with an uncertain future and high costs to Greek society, at least initially. If I was Greek, I would vote “yes” in the understanding that better conditions by creditors are the other part of the deal.

The 2014 Ukraine crisis reinforced the EU’s quest for security of gas supply. The European Commission released an Energy Union Communication in February, calling for intensified work on the Southern Gas Corridor (SGC) and for the establishment of a new strategic energy partnership with Turkey.

The Southern Gas Corridor in the EU gas security of supply architecture

Source: Bruegel.

In the last decade, the failure of the Nabucco pipeline project, combined with EU vagueness about the opening of the accession process’ energy chapter, has brought EU-Turkey energy relations to a dead-end. This situation is in the strategic interest of neither the EU nor Turkey. A coherent and actively coordinated strategy on the SGC could allow the two players to strengthen gas cooperation with Azerbaijan (to date the only prospective supplier of the SGC) and to open new, realistic, cooperation avenues with other potential suppliers in the region: Turkmenistan, Iran and the Kurdistan Region of Iraq (KRI).

The Southern Gas Corridor: reserves and pipeline projects

Source: Bruegel.

The EU and Turkey share considerable geopolitical synergies in the region, that if accurately exploited might helpunlock future gas exports from the region to their respective markets. If each potential supplier contributes 10 bcm/y by 2025-2030 the corridor might ultimately be expanded to 50 bcm/y: a significant order of magnitude for EU gas markets, most notably for southern and eastern European markets.

The Southern Gas Corridor: a potential scenario

Source: Bruegel.

But how can the EU secure such a “proactive transition”? First of all, the EU should establish dedicated energy diplomacy task forces with Turkey and with each potential supplier. This would allow the EU and Turkey to make full use of complementary diplomatic leverages in the region, and thus to ensure that barriers halting regional gas trade are overcome. The four task forces (EU-Turkey-Azerbaijan; EU-Turkey-Turkmenistan; EU-Turkey-Iran; EU-Turkey-KRI) would represent the key pillars of a new EU-Turkey strategic gas partnership.

In parallel to energy diplomacy, the EU and Turkey should establish a dedicated financing mechanism for gas infrastructure investments, with a primary focus on upgrading the Turkish gas grid (through which new volumes of gas from regional suppliers might also flow to the Turkish-EU border). The European Investment Bank (EIB) could play a key role in attracting private and institutional investors, through its wide set of financing tools. The four “EU-Turkey Energy Diplomacy Task-Forces” and the “EU-Turkey Gas Infrastructure Financing Initiative” would act under the common framework of the “EU-Turkey Strategic High Level Energy Dialogue” recently launched by the Vice-President Šefčovič and Minister Yildiz.

A new EU-Turkey strategic energy partnership

Source: Bruegel.

Any new EU-Turkey cooperation efforts on the SGC should focus on small, but feasible, bilateral projects, instead of multilateral mega-projects that, as in the case of Nabucco, have proved to be problematic in this complex regional context. The target should not be to provide new major supply alternatives for Turkish and European natural gas markets in the short term; this would be unfeasible, as realistically an expansion of the SGC will not take place before 2025-2030. Its target should rather be to secure the basis for the expansion of the Corridor in the medium term.

Tested cooperation, with relatively limited gas volumes and up to four different supply sources will do most for Europe’s long term security of supply. It is not possible to foresee the political situation in any of the source countries, but cooperation would enable Europe to increase import capacity relatively quickly, from the most appropriate sources at that point in time. Investing today in the option of expanding imports from four different sources works, without having to commit to importing gas-volumes that are currently not (and might never be) needed.

After weeks of negotiations with the European Commission and the Council of the EU, the European Parliament on 24 June adopted the text establishing the European Fund for Strategic Investment (EFSI), the instrument at the centre of Commission president Jean-Claude Juncker's investment plan. Now that the details of the plan are available we can assess more precisely how it will work and what its impact might be on European growth and employment.

What is EFSI for?

The plan tries to address the dramatic fall in investment affecting Europe since the beginning of the crisis. The yearly level of investment is currently around 10 percent (or almost €300 billion) below its long-term trend (excluding bubbles), as discussed in a previous Bruegel blog post. This fall in investment has been a significant drag on growth and employment for six years now, but it will also hold back Europe’s growth potential in the long-term. In that respect, the plan is a step in the right direction: since the beginning of his mandate, President Juncker has highlighted investment as one of his key priorities, and the investment plan was the new Commission's first flagship project.

The Juncker plan, a second-best solution?

However, the optimal response to the fall in investment would have been a massive European public investment plan either through the European Investment Bank (as suggested for instance by my colleague Zsolt Darvas), through the member states (with, for instance, the help of an improved investment clause to exempt public investment from fiscal rules), through a re-oriented European Stability Mechanism, or through another institution created for the occasion, in order to take advantage of the historically low interest rates from which European governments have benefited since mid-2014.

The solution proposed by the Commission shows that a majority of member states had no appetite for such a massive public investment plan, and the Commission has brought together only a very small amount of money relative to the extent of the investment problem affecting Europe today. The funds devoted to the Commission's flagship investment project will consist only of €8bn from a reshuffling of EU budgets from 2015 to 2020 (representing only half of the total €16bn pledged by the Commission to the EIB), and €5bn from the past profits of the EIB.

Given that the Commission has been heavily constrained by the limited funds allocated to the plan, its initial idea was to use the funds to offer guarantees to risk-averse private investors in order to finance high-risk/high-return investments. At the time, this seemed like a smart idea, and a possible second-best solution, as long as the guarantee was offered for investments that were not able to find financing, as we explained in another blog post published when the plan was revealed at the end of November 2014.

Is the Juncker plan really what the Commission claims it is?

However, looking at the details of the plan approved last week by the European Parliament, there are now some good reasons to be sceptical and to think that the plan's impact on growth and employment will be negligible. First, although EFSI is presented as a proper fund, it is important to understand that it will just be a label for some of the new EIB assets. This label will be awarded by the newly created “EFSI investment committee” (see Figure 1 below) to some projects that the EIB previously did not want to fund because it considered them too risky, and that will now benefit from the EU guarantee (even though the EIB is currently well capitalised and already benefits from a guarantee of all EU member states through its callable capital). This is also important because it makes it impossible for private investors or governments to inject capital into the “fund,” as was suggested at the beginning. The only thing they can do is participate as co-financiers of the EIB's EFSI-labelled projects. The Commission's boasts about the contributions of member states to the plan through their national development banks have to be seen in this light. It is true that this EU-level cooperation between national development banks could result in positive synergies, but the fact that Kreditanstalt für Wiederaufbau (Kfw), Caisse des dépôts (CDC), Cassa Depositi e Prestiti (CDP), Instituto de Crédito Oficial (ICO) and co. will co-finance some EFSI projects should not be seen as additional investment, but as another reshuffling of funds.

Figure 1: Summary of how the Juncker plan is supposed to work

Source: Bruegel

In the best-case scenario, the creation of EFSI would lead to a major change in the way the EIB functions (even if the EFSI assets will never represent more than 10 percent of total EIB assets). The EIB would finally take on more risk, funding high-risk/high-return projects that are not able to secure finance because of the current high risk aversion of investors because of the crisis. Indeed, as noted for instance by Moody’s, the EIB is currently characterized by its “prudent project selection” and invests mainly in very high quality assets, as suggested by the extremely low level of non-performing loans compared to other development banks (representing only 0.02% of total disbursed loans in 2013). The EIB would also accept a less dominant position by agreeing to finance a smaller share of each project to avoid crowding out private investors (currently between one third and one half, the EIB's share should diminish to one fifth to arrive at the multiplier of 15 assumed by the plan). In addition, the EIB would be junior to its co-financiers in order to really reduce the risks taken by private investors. This would increase the chances of attracting private investors to finance higher risk projects which are unable to secure funding today. In that case, even if the Juncker plan does not turn out to be the major investment plan that the Commission sold to the public, it would at least stimulate a welcome change in the way the EIB works. That said, a simple reminder from the EIB Board of Governors (composed of all the finance ministers of the EU member states) of the Bank's essential mission to use its resources to address market failures could have been enough to make that change happen, without the need to involve the Commission or the EU budget.

The costs of reshuffling funds

On the funds themselves, two points should be noted. First, the €5 billion EIB contribution from its past profits would have been used anyway to finance new projects. So while there is no cost in using this money to fund EFSI projects, there is no fresh money involved here: it is just a neutral reshuffling of money from one EIB pocket to the other.

Second, the €8bn from the reshuffling of the EU budget will be mainly taken from Horizon 2020 and the Connecting Europe facility – even if the European Parliament eventually managed to reduce their contribution to €5bn (instead of €6bn). The rest will come from the unused margins of the EU budget. As well as giving us an indication of how highly the new Commission thinks of its own programmes, some significant opportunity costs arise from taking money from the EU’s main research and innovation and transport infrastructure programmes, in order to deposit it gradually into a guarantee fund that might or might not be used, so the EIB can be insured against potential losses.

Is the EIB going to play its part fully?

Overall, the adopted Juncker plan relies on some bold assumptions about the EIB’s future behaviour that seriously look like a leap of faith: that the EIB will be able to find additional projects, that it will be able to attract much more co-financiers than usual, that the projects it will finance are more useful than those usually financed by the EU budget to generate growth and employment. The plan is also underpinned by a more general assumption that the EIB will be able to move away from its risk-averse culture to finance high-risk/high-return projects. All of this is indeed possible (in the best of all possible worlds) but the probability that all of this will be achieved does not seem very high, which leads me to think that the Commission, by giving the lead role to the EIB, has taken a huge gamble. The risk for the Commission is that its flagship investment plan will not be the game-changer announced last year and that its impact in terms of growth and employment will be very limited.

Looking at markets more broadly, we can see that since Monday’s opening, volatility (as captured by the VSTOXX index) is up slightly from 26, peaking at about 32 and returning to around 30 at the time of writing and tending down recently.

The Euro quickly made up the losses incurred at market opening on Monday (29.06), however it has once again slid down against the dollar slightly.

With the current situation in the ongoing Greek debt negotiations taking a turn for the worse this weekend, we take a look at other Euro area interest rates on long-term debt to gauge how markets have reacted to the news of a Greek referendum on the Eurogroup's proposals, and the imposition of capital controls.

So far, markets have reacted in a fairly benign way, especially when put in the context of developments between 2010 and 2012.

Spain, Italy and Portugal show the biggest market reactions to the weekend’s news, with yields temporarily increasing by 22, 23 and 28 basis points respectively, from the last data on Friday to the point at which markets opened today. The markets have dampened their reaction since then somewhat (as shown by the red bars) in Spain and Italy.

Figure 3: Historical perspective of 10 year sovereign yields (%)

Source: Thomson Reuters Datastream

Taking a broader look at volatility, the VIX and VSTOXX indicies do not show significant signs of major stress yet, although the VSTOXX, the European index, has diverged locally from the VIX recently, but this evolution has been ongoing since before the weekend's events.

Figure 4: VIX volatility index

The government of Greece has rejected the creditors’ conditions of the continuing bailout program and is heading to imminent default on its obligations vis à vis the International Monetary Fund (end-of-June) and European Central Bank (July).The chaotic manner in which negotiations were broken off, and Prime Minister Tsipras’ decision to call a referendum on July 5, 2015 on accepting or rejecting creditors’ conditions triggered an immediate banking panic: people in Greece started to queue at ATM machines to withdraw cash from their accounts.

Greece’s banking sector has already been under huge pressure since Syriza’s parliamentary victory

In fact, Greece’s banking sector has already been under huge pressure since Syriza’s parliamentary victory in January 2015. Only the systematically increasing liquidity support of the ECB, through the Emergency Liquidity Assistance (ELA) special lending facility has kept banks afloat.

From default to Grexit – the hypothetical scenarios

Does Greece’s sovereign default and banking crisis mean its immediate and automatic exit from the Eurozone as many commentators have suggested? The short answer is not necessarily and, definitely, not immediately. Leaving aside quite complicated legal issues, such as the lack of a formal procedure for leaving the Eurozone, let us concentrate on different economic scenarios, which may or may not lead to Grexit. In any case, an exit is unlikely to happen during the next few days or weeks.

Considering hypothetical scenarios of leaving the Eurozone (Dabrowski, 2012), the most likely variant could be involuntary exit caused by lack of another option acceptable to Greek authorities or loss of control on macroeconomic developments. Two other potential scenarios, such as a voluntary and deliberate decision by Greece to leave the Eurozone and reintroduce its national currency, an involuntary exit forced by other EU/Eurozone members do not look probable. Most of Greek society, including the ruling Syriza party, wants to keep the Euro. The remaining EU partners have neither the legal instruments, nor the interest to force Grexit.

The first trigger - banking crisis

Greece’s involuntary exit from the Eurozone may be triggered by a banking crisis

In the current situation, Greece’s involuntary exit from the Eurozone could be triggered, in the first instance, by a banking crisis. Facing a run on bank deposits and having frozen the size of ECB liquidity support at the level of June 26, 2015, the authorities had to introduce limits on cash withdrawals and money transfers outside Greece and announced bank holidays for one week, most likely subject to further extension. In case of reduction or complete withdrawal of the ELA support, banks will have to be closed immediately because they will become both illiquid and insolvent.

Although living with closed banks and frozen deposits is technically possible (as demonstrated, for example, by the US banking crisis in the early 1930s or, in a lighter form, in Cyprus in 2013), this cannot last for long. This is the case even in Greece, where the general population and small businesses are used to relying on cash operations, and large enterprises often operate via foreign banks. Sooner or later, the government may want to offer the owners of blocked Euro deposits the chance to voluntarily convert them into the new national currency, a move which would require reverting to a national monetary policy (to provide banks with liquidity in the new currency) and then printing new banknotes and coins to allow free deposit withdrawals.

Another hypothetical sub-scenario involves taking political control over the Bank of Greece (in violation of the EU treaties) and forcing it to act against ECB instructions, i.e., providing commercial banks with liquidity support beyond ECB limits and lending conditions (related to eligible collateral and its quality). This kind of “rebellion” was observed both in the former USSR and in former Yugoslavia during their political disintegration between 1990 and 1992. The republican central banks (formally the branches of the State Bank of the USSR or the National Bank of Yugoslavia) started to issue credit money on their own, without authorization from their headquarters.

The most likely ECB reaction to such hypothetical scenario would be cutting Greek banks off from the Target-2 payment system. As a result, the Euro non-cash turnover in Greece would become separated from the remaining part of the Eurozone. Once owners of Euro deposits learn about this separation, they would likely start testing the ability of local banks to cash their deposits, leading to either bank closures or the necessity to print local cash currency.

The second trigger – government cash shortage

Since 2013, Greece has enjoyed a primary fiscal surplus. That is, the government can pay salaries, pensions and other current bills out of current revenues, especially if it stops serving its debt. However, the increasing uncertainty associated with the economic policies of the Syriza government and negotiations with creditors have recently led to problems in revenue collection (Merler, 2015). The chaos caused by the failure of the bailout negotiations, sovereign default and banking crisis, could cause the situation to drastically deteriorate in the coming weeks.

Facing a cash shortage, the government may postpone its payments and continue building up arrears (which already exist) as was done by several governments in the former USSR in the 1990s. However, this solution would work for a few weeks, perhaps months, not longer, and the consequences for payment discipline in the entire economy are obviously negative. At some point, the government may try issuing promissory notes or other kinds of monetary substitutes. Even if denominated in Euro (still the official legal tender), these substitutes would be traded on the private market at a discount. And the government would have to accept them as the means of payment, for example, of taxes or fees for government services. If it remains unable to redeem them at nominal value in some reasonable period of time, a parallel currency, a kind of “local” Euro will be de facto installed. This is another avenue, which may lead Greece to gradual departure from the Eurozone.

Doubtful benefits of leaving the Eurozone

Could leaving the Eurozone help Greece to solve its economic and fiscal problems as suggested by many commentators? According to them, reintroducing a weaker national currency would allow the country to regain its external competitiveness. However, today competitiveness is not such a dramatic problem as it was a few years ago, thanks to the progress in structural reforms achieved in recent years (Darvas 2015). Furthermore, Greece’s exports have not reacted much to decreases in wage costs due to other factors such as rigid product markets and limited innovation (Wolff 2015; Velasco 2015), the policy areas that require further deep reforms. The structure of Greece’s exports (the large share of international services) also plays a role (Gros, 2015).

Exiting a highly integrated monetary union with a single legal tender in which all the contracts are denominated in a common currency, is a much more complex and hazardous operation than a simple devaluation of the national currency (like the devaluation of the British pound in 1992). Even such an “ordinary” devaluation is usually contractionary in the short-term, because it negatively affects domestic demand. In countries in which a substantial part of public and private debt is denominated in foreign currency, the consequences of a devaluation are much more severe (like the example of Argentina in early 2000s) as the size of external liabilities increases in the local currency and in relation to GDP.

A departure from the Eurozone would mean an immediate default on all public and most private liabilities

A departure from the Eurozone would mean an immediate default on all public and most private liabilities, as old contracts would remain denominated in Euro. Any attempt to redenominate them involuntarily into the new weaker currency (as well as the discrimination of residents against non-residents or vice versa) would involve serious legal objections that are not easily overcome in an EU country with democratic rule-of-law.

The economic chaos resulting from exiting the Eurozone, a collapse of the financial system and a rapidly deteriorating economy would further reduce tax revenues and, therefore, the capacity of the government to provide basic public goods and services.

Technical and economic challenges of new currency

Finally, reintroducing a national currency (unlike currency devaluation) is quite a complex technical operation, which requires time and the administrative capacity to be prepared in secrecy. The operation itself would most likely have to include a temporary bank holiday and the reintroduction of customs controls on a country’s borders to stop the outflow of euro cash. Given the inexperience of the current government, the weakness of the Greek public administration and potential opposition to leaving the Eurozone, it may pose a serious challenge.

Despite its formal status as legal tender, a new currency might not be trusted and accepted by economic agents who would prefer to continue using the euro. If not supported by tough monetary and fiscal policies (a rather unlikely scenario for the government, which just rejected the much softer conditionality of the bailout package) a new currency would rapidly depreciate, which could lead to high inflation or even hyperinflation. This was the experience of many of the successor states of the former Austro-Hungarian Empire (after 1918), as well as the former Soviet Union and former Yugoslavia (both after 1991).

It’s not too late to avoid havoc

Greece faces an uneasy period of serious financial, economic and (perhaps) political turbulence. Whether the rejection of the “Troika” bailout package and the resulting sovereign default will lead to exiting the Eurozone and reintroducing national currency is hard to tell. If it eventually happens, it will take several weeks or months. However, Grexit does not need to happen. There is still a window of opportunity (although rapidly decreasing over time) for the Greek government to come back to the negotiation table and relaunch economic reform. The result of the forthcoming referendum will play a decisive role.

Defying hopes that negotiations could lead to an agreement between Greece and its creditors by the end of the week and ahead of the programme expiring, PM Tsipras announced on Friday evening that he would call a referendum to allow the Greek people to express their view about the latest creditors´ proposal. Based on Tsipras’ speech, the decision to call for a referendum rests on the government’s conviction that accepting the proposal on the table would be beyond its mandate, because the proposal would be in conflict with the electoral platform the government was elected on. Finance minister Varoufakis also commented along these lines, saying that for such a major decision the Greek government felt it ought to consult the Greek people and receive the backing of more than 50% of the citizens.

On Saturday night, the Greek parliament authorized the referendum, with a total of 178 lawmakers backing the proposal and 120 voting against it (the threshold for authorization being 151 votes). Kathimerini reports that deputies from the far right Golden Dawn voted with the government, while opposition parties New Democracy, PASOK and To Potami and the KKE Communist Party voted against. The referendum will therefore be held in a week, on Sunday the 5th of July. According to the Greek government´s proposed question, Greek people will be asked to answer the following:

"The Greek people are asked with their vote whether to accept the outline of the agreement submitted by the European Commission, the ECB and the IMF on the Eurogroup of 25th June 2015 and consisting of two documents, which form the basis upon the referendum question will be asked: the first document is titled "Reforms for the completion of the Current Program and Beyond" and the second document is titled "Preliminary debt sustainability analysis".

Whichever citizen rejects the institutions' proposal votes NO.

Whichever citizen accepts the institutions' proposal votes YES"

The government will be campaigning for NO, rejecting the creditors’ proposal.

The Documents

If views on the primary surplus targets are now aligned, views on how to fill the fiscal gap in the supplementary budget are definitely not.

The referendum question will be based on the people's assessment of the creditors' proposal of June 25th. This is the proposal that was supposed to be sent to the Eurogroup for discussion - posted by the Financial Times - and it is identical to the document published yesterday by the European Commission “in the interest of transparency and for the information of the Greek people”. This proposal was considered unacceptable by the Greek government and incompatible with the mandate that it had received based on the electoral platform it had run on. Before talks broke down on Friday, however, the Greek government had advanced a counterproposal - which was also leaked and posted by the Financial Times. It may therefore be useful to recall here the main points of the creditors’ proposal, as opposed to this later Greek counterproposal, which presumably the Greek government would consider acceptable and compatible with its mandate.

On the primary surplus target, the creditor text foresees targets of 1, 2, 3, and 3.5 percent of GDP in 2015, 2016, 2017 and 2018. Both sides agree on these targets, and as already pointed out on this blog during the earlier phase of the negotiations, 1 percent of GDP in 2015 is below the target that finance minister Varoufakis unsuccessfully bargained for during the first Eurogroup he attended. This is a significant concession by the creditors from their initial demands, but the problem is that the deterioration of the Greek economy over recent months has been such that now even this “concession” translates into the need to adopt a supplementary 2015 budget (which would be effective as of July 1st). If views on the targets are now aligned, views on how to fill this fiscal gap in the supplementary budget are definitely not.

One set of measures would be based on corporate taxes. Both sides agree to an increase in the corporate income tax rate from 26% to 28% in 2016 budget (although the Greek side initially proposed 29%, scaled down by creditors). But there is disagreement on what to do in the shorter term. The creditors’ document asked for the introduction of a 100 percent advance payments for corporate income as well as individual business income tax by end-2016, which the Greek side eliminated in their latest counterproposal. On the other hand, the Greek government wanted to reinsert a one-off corporate tax of 12% on corporate profits over EUR 0.5 million, to meet the fiscal target for 2015. This was in the initial greek offer, but creditors had opposed it.

Another fiscal measure on which there is disagreement is military expenditure, which the creditors are asking to be reduced by 400 million whereas the Greek counterproposal offered 200 million, with the gap presumably to be filled by “increased tonnage tax” and the implementation of an “effective taxation framework for commercial shipping”, two measures that were not discussed in the creditors´ offer.

On VAT reform – a highly debated issue over the last month – creditors backed down from their initial demand to unify VAT rates under a single one or two at most, and agreed to keep the three rates system – including reducing the lowest rate from 6.5% to 6% as in the initial Greek proposal. The counterpart of this would be a reshuffling of the items across the rate bands, with the objective to achieve a net revenue gain of 1 percent of GDP on an annual basis from parametric changes. One important concession from creditors on VAT is the acceptance of the Greek demand that energy remains in the 13% rate band rather than being moved to the 23% one. One irremovable demand from creditors is instead the removal of the reduced VAT rates on Greek island, which is a politically difficult concession for the Greek government to swallow. The latest Greek counterproposal in fact wanted to reintroduce that discount, leading to a lower objective (0.93% of GDP) for VAT revenues gain than what was required by creditors.

On pensions, which was probably the most sensitive and politically charged subject of discussion during the whole negotiation phase, the 25th June offer shows that positions still remained divergent as of last week. Creditors asked for the retirement age to be increased to 67 by 2022, while the Greek side initially proposed 2036 and later offered 2025. The biggest point of contention is however the EKAS “solidarity grant”, which provides top-ups for poor pensioners, and is therefore an extremely sensitive issue. Creditors asked initially for the phase out of this grant by 2017, but the June 25th proposal appeared to agree to phasing out by 2019, one year earlier than the Greek side was ready to offer (2020). The institutions would however require that the phase out starts immediately for the top 20% of beneficiaries, something that Friday’s Greek counterproposal was rejecting, together with the request to freeze monthly guaranteed contributory pension limits in nominal terms until 2021. Concerning the increase in health contributions for pensioners - which was originally proposed by the Greek government - the creditors´ proposal includes an increase from 4% to 6% on average.

The Question and polls

The attempt of this summary is to be informative about the existing positions, as objectively as possible.

Surveys have consistently shown that a significant majority of the Greek people want to stay in the euro.

As is often the case in referendum votes, objectivity is not the only variable, and the way the question is asked and presented by the different parties can have a significant impact on voters’ behavior. Based on Tsipras´ speech and the accounts of parliamentary discussions, it seems the government will frame the vote as a decision between preserving sovereignty and accept the imposition from creditors who – Tsipras said in previous occasions – would attempt to humiliate the Greek government and people. The opposition will instead frame the vote as a decision on Greece’s eurozone membership, which a NO vote could de facto undermine.

Polls seem to reflect a similar polarization. Over the past months (and years) surveys have consistently shown that a significant majority of the Greek people want to stay in the euro. But polls specifically about the support for a deal with creditors have varied significantly.

A survey by the Alco polling institute published in Sunday's edition of Proto Thema newspaper and reported by reuters, said 57% out of 1,000 respondents were in favour of reaching a deal, while 29% wanted a break with creditors. Another poll by Kapa Research, which asked 1,005 respondents how they would vote if a new "painful" agreement were put to the vote in a referendum, yielded a significantly lower 47.2% of respondents in favor of an accord and 33% against, with more than 18% of undecided. This means that there are a very high number of swing voters. The same poll showed a worryingly small 48.3% of respondents saying they would not support any move by the government which could place Greece outside the euro zone. These polls were all taken before the imposition of capital controls, therefore a crucial question will be how the latest developments have shifted the votes of the undecided.

Timing and general conclusion

The Greek programme expires tomorrow. The Eurogroup statement issued on Saturday 27 July plainly reiterates this fact, but does not include any indication that the deadline will be extended a few days after the referendum. Without extension, the referendum will be pointless. I agree with my colleague Zsolt Darvas that at this historical moment euro-area leaders should allow Greek people to make their voices heard, and that the Eurogroup should explicitly grant this exemption. If the outcome of the vote is a YES, than a deal will still be possible. Many aspects of the current proposals will likely need to be reconsidered, in light of the period of capital controls.

The time has really come to live up to promises, on both sides.

In particular, it is worth remembering that the summer months (especially July) are key months for state revenue collection, as has been previously shown on this blog. Revenues were already significantly underperforming in May, and we don't know what the impact of the current situation will be. The recent statement by the Commission shows that a more pessimistic position from the creditor side could be possible, in the case of a YES vote. It says that "the understanding of all parties involved was that this Eurogroup meeting should achieve a comprehensive deal for Greece, one that would have included not just the measures to be jointly agreed, but would also have addressed future financing needs and the sustainability of the Greek debt". This is something creditors committed to in 2012.

On his part, PM Tsipras also made promises to his people, which certainly did not entail capital controls or euro exit. The commission statement also makes reference to a " package for a new start for jobs and growth in Greece, boosting recovery of and investment in the real economy", which should be part of the deal and allow Tsipras to fulfill at least some of the commitments he made his people for a brighter future. My personal opinion is that the time has really come to live up to promises, on both sides. But this will only be possible if the Greek people take the leap of faith to vote for a YES.